The Bombay High Court ruling in the case of IDBI Trusteeship Services Limited v/s Hubtown Limited dated 8 May 2015 has been set aside by the Supreme Court in its order dated 15 November 2016. The attached note sets out a summary of the judgment and its possible implications under foreign exchange regulations where the parties have structured the transaction with an element of guaranteed returns.

FACTS

1) Nederlandse Financierings-Maatschappij voor Ontwikkelingslanden N.V. (“FMO”), a Dutch Company, invested in certain equity shares and compulsorily convertible debentures (“CCDs”) of an Indian Company, Vinca Developers Private Limited (“Vinca”). Upon conversion of the CCDs, FMO would be entitled to 99% of the voting and economic rights in Vinca. The Defendant, Hubtown Limited (“Hubtown”) and its promoters Hemant Shah and Vyomesh Shah held the entire Class A equity shares and Class B equity shares of Vinca.

2) As per the terms of subscription set out in the share subscription agreement for the above investment by FMO (“SSA”), the proceeds of FMOs investment in Vinca, were not to be retained by Vinca or used by Vinca in its own projects, but were to be invested in certain secured, non-marketable, transferable optionally and partially convertible debentures (“OPCDs”) of Amazia Developers Private Limited (“Amazia”) and Rubix Trading Private Limited (“Rubix”).

3) Vinca invested in OPCDs of Amazia and Rubix in terms of the SSA. The OPCDs carried a variable running coupon and a back ended coupon to ensure an internal rate of return of 14.75% per annum. IDBI Trusteeship Services Limited (“IDBI”) was appointed as the debenture trustee for the OPCDs issued by Amazia under a debenture trust deed dated December 1, 2009, and Rubix under a debenture trust deed dated September 8, 2010 (“Trust Deeds”). The Trust Deeds also provided that the proceeds of FMOs investment in Vinca, were not to be retained by Vinca or used by Vinca in its own projects, but were to be invested in OPCDs of Amazia and Rubix.

4) Further, in order to secure the OPCDs, and to ensure due payment of dues by Amazia and Rubix, Hubtown executed a corporate guarantee dated December 9, 2009, providing unconditional, absolute and irrevocable corporate guarantee in favour of IDBI , inter alia for the benefit of Vinca (“Guarantee”).

5) Amazia and Rubix defaulted in payments of interest and default interest, providing financial statements, maintaining debt to EBIDTA ratio, and various other covenants by which Amazia and Rubix were bound under the terms of the Trust Deeds. Further, despite various notices in respect of such defaults, Amazia and Rubix, failed to rectify defaults. Therefore IDBI issued redemption notices to Amazia and Rubix for early redemption of the OPCDs. Thereafter, since Amazia and Rubix did not pay the amounts due and payable in terms of the Trust Deeds IDBI issued a demand certificate on August 3, 2012 for the enforcement of the Guarantee to Hubtown. Hubtown did not make such payments to IDBI upon receipt of the demand certificate.

6) IDBI thereafter filed a summary suit for recovery of the sums along with interest from Hubtown before the Hon’ble Bombay High Court (“Bombay HC”). Hubtown admitted its liability to make payments, but sought a ruling that the Guarantee was unenforceable since it was in violation of extant foreign exchange regulations. In its judgment on the summons for judgment in the above summary suit, the Bombay HC disregarded Vinca in the structure, since Vinca, in its view was interposed only for the purpose of structuring FMO’s foreign investment into Amazia and Rubix, to provide a facade of compliance with the extant foreign exchange regulations and was only a nominal recipient of the foreign investment. The structure of the investment in fact was designed to provide FMO a guaranteed return of 14.5% per annum on its foreign investment in India, and was violative of extant foreign direct investment policy and the foreign exchange regulations, which prohibits such guaranteed returns, and was therefore illegal and unenforceable. Consequently the Guarantee was also unenforceable. Accordingly, leave was granted to Hubtown to defend the suit, without the deposit of any sums due under the Guarantee.

7) IDBI then filed a special leave petition before the Hon’ble Supreme Court of India (“Hon’ble Supreme Court”) against the above judgment of the Bombay HC.

RATIONALE OF THE HON’BLE SUPREME COURT:

1) The suit was filed by IDBI, a person resident in India, for invocation of the unconditional Guarantee, for the benefit of Vinca, another person resident in India. Under this transaction, no funds would be going out of India, in violation of any foreign exchange management regulations, the funds realised are for the benefit of Vinca which is an Indian company.

2) FMO becoming a 99% holder of Vinca after conversion of the CCDs, would also not prima facie breach foreign exchange regulations, and it would be permitted use the funds received by Vinca pursuant to the above transaction as per extant laws.

3) If the funds in Vinca are proposed to be repatriated, permission of the Reserve Bank of India (“RBI”) would be required.

4) The conduct of Hubtown in not making payments upon invocation of the corporate guarantee leaves doubt about the good faith of Hubtown, and therefore, it would be required to deposit the principal sum involved in the dispute before the Bombay HC for the defence of the suit.

OUR OBSERVATIONS AND COMMENTS

1) The RBI had by a notification No. FEMA 294/2013-RB dated November 12, 2013 (“RBI Notification”), and further by A.P. (DIR Series) Circular No. 86 dated January 9, 2014 (“RBI Circular”) amended Regulation 9 of the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident outside India) Regulations, 2000 (“FEMA 20”) to among other things, provide that non-residents investors are not permitted an assured exit price at the time of making such investment and shall exit at the price prevailing at the time of exit. All existing contracts were required to comply with the provisions of the RBI Circular for compliance with FEMA 20.

2) It is significant that the Hon’ble Supreme Court (i) directed Hubtown to deposit INR 418 crores to defend the suit without having delved into the merits of the case or adjudicated whether the foreign investment by FMO is in violation of FEMA 20, and (ii) did not focus on the fact that the ultimate 99% beneficiary of a favourable judgment for IDBI was FMO, and observed FMO and Vinca would have to separately ensure compliance of extant foreign exchange law if any of the proceeds of the suit were proposed to be repatriated outside India, once realised. The Hon’ble Supreme Court appeared reluctant to uphold the relief granted to Hubtown from its contractual obligations merely on the ground that investment structure used by FMO may not be compliant with extant foreign exchange law.

Interestingly, the Hon’ble Supreme Court in Vodafone Holdings BV v. Union of India ((2012) 6 SCC 613), sought to examine at the entire transaction, rather than looking at the prima facie facts, to determine whether a series of transactions have been used as a colourable device to contravene an existing law, and rendered such structures void.

It appears, and in a way it is good for foreign investors that the Hon’ble Supreme Court in IDBI v. Hubtown, has signalled reluctance towards granting Indian Parties relief that will enable them to renege from their contractual obligations by challenging the compliance of foreign investment structures with Indian foreign exchange law, especially when such Indian Parties were a privy to such structures. This in addition to legislative reforms should provide foreign investors additional incentive to invest in India.

3) Since February 2015, the stated policy of the RBI (as provided in its bi-monthly monetary statement) is to permit more flexibility in pricing of unlisted securities. It will be interesting to observe whether the RBI chooses to initiate proceedings against FMO or Vinca on the basis of the transaction structure, especially since the Hon’ble Supreme Court has not made a ruling on the validity of the structure, but chosen to merely have the case adjudicated on its merits by the Bombay HC. Further, we know about the controversy in the Tata Docomo matter and about such structures. We would have to wait to see whether the RBI would seek to liberalise pricing, and returns on securities to legitimise such structures going forward.

Disclaimer: The information provided in this update is intended for informational purposes only and does not constitute legal opinion or advice. Readers are requested to seek formal legal advice prior to acting upon any of the information provided herein. This update is not intended to address the circumstances of any particular individual or corporate body. There can be no assurance that the judicial/ quasi judicial authorities may not take a position contrary to the views mentioned herein.