A recent Bombay High Court ruling on the legality of transaction structures could make foreign investors cautious about India.
The Bombay High Court, in the matter of IDBI Trusteeship Services Ltd. vs. Hubtown Ltd, has ruled on the legality of transaction structures of foreign direct investment. The court has classified the transaction structure that involves compulsory convertible debentures (CCDs) issued by an Indian company to a foreign investor and the proceeds of such investment used by the Indian company to further invest through optionally convertible debentures (OCDs) of other companies operating in the construction development sector as an illegal structure that violates the FDI policy.
As a background, a Dutch entity invested, by way of CCDs and approximately 10% of equity shares, in the Indian investee company, Vinca Developers Private Limited (Vinca) for a total consideration of R418 crore. As per the terms of issuance of the CCDs, they were convertible within a period of 60 months and such conversion would have resulted in the foreign investor holding 99% shares in Vinca. The investment received by Vinca from the Dutch firm was utilised by Vinca to invest in OCDs issued by two of its wholly-owned subsidiaries. The OCDs, among others, provided for an interest at the rate of 14.5% p.a. Further,
IDBI Trusteeship was appointed as debenture trustee and Hubtown Limited issued a corporate guarantee to secure the liability from the OCDs. It is relevant to note that both the wholly-owned subsidiaries of Vinca were engaged in the construction development sector.
Due to the failure of the wholly-owned subsidiaries to redeem the OCDs as per the terms of issuance, IDBI invoked the corporate guarantee, pursuant to which Vinca terminated IDBI’s appointment as debenture trustee and certain other corporate actions were undertaken. On account of the said actions by Vinca, IDBI approached the court for seeking invocation of the corporate guarantee.
In this regard, it is relevant to note that in accordance with the FDI policy, a foreign investor can invest in India only by way of equity or compulsorily convertible instruments. Further, a foreign investor is eligible to exit without any assured return, as per the periodic pricing/valuation guidelines issued by the Reserve Bank of India.
In its ruling, the court viewed the legality of the corporate guarantee through the prism of legality of the transaction as a whole without separately considering each tranche of the transaction. The investment by the Dutch entity in Vinca and Vinca’s subsequent investment in its wholly-owned subsidiaries were viewed to be the same transaction from the perspective of FDI policy. The court held that the second investment, in the wholly-owned subsidiaries, was a colourable structure designed to enable the Dutch entity to invest through non-equity instruments (i.e., OCDs, in this case) without complying with the FDI policy (which only permits investments through equity instruments). Also, the 14.5% interest rate was categorised by the court as a mechanism to provide assured return to the Dutch entity on its investment. The court also held that since the corporate guarantee issued to IDBI was pursuant to the transaction that did not comply with the FDI policy and foreign exchange regulations, the said guarantee was held to be prima facie illegal and unenforceable.
Interestingly, the court, relying on the decision of the Supreme Court in Vodafone International Holdings BV versus Union of India, held that a transaction is required to be viewed as a whole, and a dissecting approach should not be adopted. Accordingly, the court held that neither IDBI nor the Dutch entity can seek the assistance of the court to enforce a prohibited/illegal transaction. The court further observed that an Indian company, which has received foreign investment, can utilise its funds for downstream investment only for making investment by way of equity or compulsorily convertible instruments. It is pertinent to note that the judgment cannot be viewed as a final verdict of the court regarding the matter and it will be interesting to see the final verdict.
For many Indian real estate companies, that have in the past argued on the enforceability of contracts which violate the FDI policy, this judgement is certain respite. Pending an outcome of this case, the foreign investors must take a more cautious approach before bringing any foreign investment into India.
RBI has time and again indicated its intention to liberalise the pricing of instruments, including assured returns, etc. May be it is now time to bring the much needed liberalisation to improve investor confidence.
With contributions from Prakriti Jaiswal, associate, J Sagar Associates, Advocates and Solicitors.
The author is partner, J Sagar, Associates, Advocates and Solicitors.
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