On November 15, 2016, the Supreme Court delivered an important judgment in IDBI Trusteeship Services Limited v. Hubtown Ltd[1], a case involving investment in India by a foreign investor. While the main thrust of the judgment was on circumstances under which a defendant may be granted leave to defend in a suit for summary judgment, the observations of the court in the context of the structure in consideration provides important indicators as to how courts should look at structured transactions.

In brief, the facts of the case are as follows. FMO, a non-resident foreign entity, made an investment into an Indian company, Vinca Developer Private Limited (Vinca) by way of compulsorily convertible debentures (CCPS) and equity shares. The CCPS were to convert into 99% of the voting shares of Vinca. The proceeds of the investment were further invested by Vinca in its wholly owned subsidiaries, Amazia Developers Private Limited (Amazia) and Rubix Trading Private Limited (Rubix) by way of optionally convertible debentures (OPCDs) bearing a fixed rate of interest. IDBI Trusteeship Services Ltd. (Debenture Trustee) was appointed as a debenture trustee in relation to the OPCDs, acting for the benefit of Vinca. Hubtown Limited (Hubtown) also issued a corporate guarantee in favour of the Debenture Trustee to secure the OPCDs.

Amazia and Rubix defaulted on the OPCDs and Hubtown, being called upon to pay under the guarantee, failed to do so. Accordingly the Debenture Trustee filed a summary suit against Hubtown in the Bombay High Court. The Bombay High Court granted Hubtown an unconditional leave to defend in the summary suit. The order of the High Court proceeded on the premise that the various transactions including the CCPS and OPCDs should be construed as a whole, since the court was of the view that they constituted a colourable device for providing assured return to the foreign investor, which according to the High Court was violative of the FEMA guidelines. The Bombay High Court found that since Vinca would be owned by FMO upon conversion of the CCDs, by virtue of the fixed return on the OPCDs, FMO was indirectly obtaining a fixed return on its investment (which is not allowed under certain circumstances in the FEMA guidelines). The court further held that the investors, having participated in the illegality, could not seek the assistance of the court to recover amounts invested illegally.

While this order made by the Bombay High Court only meant that the matter would now go to trial, some of the observations of the court created concerns on permissibility of structured transactions and whether the same would fall foul of the FEMA regulations, the interpretation of ‘assured return’ and the recourse that investors would have in such circumstances vis-à-vis investee companies.

The order of the Bombay High Court was challenged before the Supreme Court. The Supreme Court adopted an entirely different approach from the Bombay High Court insofar as it viewed the transaction in different stages and concluded that none of the stages taken individually would prima facie violate the FEMA regulations.

The court noted that the investment was made by FMO in Vinca for subscription to shares as well as compulsorily convertible debentures. This transaction was not violative of the FEMA regulations. The investment made by Vinca in Amazia and Rubix by way of OPCDs was also prima facie in compliance with FEMA regulations. Further, once the corporate guarantee was invoked, a payment made under the corporate guarantee would be a transaction between residents. At this stage also prima facie again, there was no infraction of the FEMA regulations.

The court further held since FMO was to become a 99% holder of Vinca after the requisite time period had elapsed, FMO would at that stage have the ability to utilise the funds received pursuant to the overall structure in India. Again prima facie there would have been no breach of FEMA regulations. At the stage that FMO wishes to repatriate such funds, RBI permission would be necessary. If RBI permission were not granted (and therefore the amounts were retained in India), then again there would be no infraction of FEMA regulations.

The Supreme Court further examined the different categories of defences that a judge should keep in mind before granting an unconditional leave to defend in a summary suit. The court held that in the present case, the defence of the defendant was in the realm of ‘plausible but improbable’ as the defendants had initially serviced the OPCDs before occurrence of the default and also there was no prima facie breach of the FEMA regulations. The court accordingly directed Hubtown to deposit the principal amount claimed under the guarantee as a precondition to defend the suit.

The judgment of the Bombay High Court, which viewed the various aspects of the transaction in a composite manner, caused concern in relation to the enforceability of structured transactions. Also relevant, in the context of challenges to transactions on the basis of infraction of FEMA regulations, is the judgment of the Delhi High Court in Srm Exploration Pvt. Ltd. vs N & S & N Consultants S.R.O.[2] This case arose out of a challenge to a corporate guarantee provided by an Indian company in violation of FEMA regulations. The court upheld the guarantee on the basis that, while this act may be liable to penalty for breach of the FEMA regulations, the legislative intent was not to void a transaction even if it is in violation of the FEMA.

The Supreme Court’s approach in the Hubtown case should provide comfort to the investor community on the approach that should be adopted by courts in considering such transactions in future. Further, this is a step forward in relation to certainty of contractual obligations undertaken with Indian parties and reinforces the favourable foreign investment climate in India.

[1] Civil Appeal No.10860 of 2016 decided on November 15, 2016

[2] CO.APP. No.23-24/2011 decided on March 21, 2012