In a decision which is likely to be viewed by foreign investors favourably, the apex court in the matter of IDBI Trusteeship Services Limited versus HubTown Limited upheld a structured equity transaction, with downstream investment in debt securities, which was backed by guarantee from Indian obligors.
The Bombay High Court (HC) had previously held such structure to be a colorable device and in violation of the Indian exchange control regulations.
This article traces the journey so far on this case to evaluate the position of the foreign investors in structuring a transaction with appropriate downstream protection on one hand and the ability of the Indian obligors to not honour such contractual obligations on the other hand.
NederlandseFinancierings- MaatschappijiVoorOntwikkelingslandeo N.V. (FMO), the foreign investor invested in Vinca Developers Private Limited (Vinca/Hold Co) through the foreign direct investment route and subscribed to 10% equity shares and three compulsorily convertible debentures (CCDs). Upon conversion, the CCDs would provide FMO a 99% shareholding interest in FMO.
- Investment of Vinca in its subsidiaries
Vinca contractually agreed that the amount of investment received from FMO would be used to purchase optionally partially convertible debentures (OPCDs) of its subsidiaries, being Amazia Developers Private Limited (Amazia) and Rubix Trading Private Limited (Rubix). Amazia was engaged in development of an industrial park and Rubix was engaged in a slum rehabilitation project being undertaken in Mumbai. The OPCDs carried an interest rate of 14.5% per annum.
- The full redemption of such OPCDs was guaranteed by Hubtown Ltd and IDBI Trusteeship Services Ltd was appointed as the debenture trustee for the OCDS.
- Upon failure by Amazia and Rubix to make the payments on the OCDs, the guarantee provided by Hubtown was invoked. Subsequently, upon failure of Hubtown to make the payments pursuant to the invocation of the guarantee, the Debenture Trustee filed a petition for winding up Hubtown and also a summary suit for recovery of the dues.
CURRENT REGULATORY FRAMEWORK
Investment of 100% in construction development is permitted only by way of instruments considered as equity under the foreign exchange regime namely, equity shares, compulsorily convertible preference shares and CCDs. Further, providing any assured rate of return in a foreign direct investment is not allowed.
BOMBAY HIGH COURT RULING
- The HC ruled that the transaction of routing foreign investment through the newly interposed Vinca is a colorable device purported to circumvent the Indian exchange regulations.
- Such structure was provided to enable FMO to secure repayment (through Vinca) of its foreign investment amount and interest thereon at 14.75%, contrary to the foreign exchange regulations.
- The guarantee was therefore part of the aforesaid illegal structure/scheme and therefore prima facie illegal and unenforceable.
SUPREME COURT RULING
The apex court, in deciding whether unconditional leave to defend must be granted to the defendant (for a detailed trial in the HC), analysed the transaction structure and made the following observations:
- Since the guarantee was provided from one Indian entity (Hubtown) to another Indian entity (Vinca), it did not violate the foreign exchange regulations; and
- The overall transaction structure pursuant to which FMO becomes a 99% shareholder in Vinca and Vinca receives funds from Amazia and Rubix upon redemption of OPCD was prima facie held valid. It was further held that FMO may upon becoming 99% shareholder utilize the funds received pursuant to the overall structure agreements in India and such structure was prima facie not in violation of the foreign exchange regulations.
- Based on the above analysis, the apex court opined that the defence raised appears to be at best in the realm of ‘plausible but improbable’ and, therefore, allowed Hubtown to defend the suit only upon deposit of the principal sum invested by FMO, or provide security for the said amount.
- The judgment allows enough flexibility to structure foreign investments to achieve the desired downside protections, including by way of utilising the cash flows of the downstream companies.
- The decision gives comfort to the investors looking at multi layered structures, so long as each layer independently conforms to the relevant foreign exchange regulations. Investments by way of an Indian owned and controlled entity becomes easier with the option to now choose from a range of instruments for investing downstream. Further, if each layer of the structure conforms to the relevant regulation, the risk assessment of investing in a ‘controlled’ sector becomes easier and more predictable in so far the comfort can be drawn on the basis of the wording of the regulation as opposed to the ‘intent of the regulator’!
- The fact that Hubtown (as a guarantor) was asked to deposit the principal amount of OPCDs before being allowed to dispute its guarantee obligation will also serve to deter the Indian issuers and obligors from misusing the court process to circumvent contractually agreed payment obligations to foreign investors.
Abhinav Surana is Partner, Sumitava Basu is Senior Associate and Kanika Mathew is Trainee at law firm Juris Corp.
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