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Hubtown: FDI, Assured Return & Downstream Investments

Published on Fri, May 29,2015 | 07:34, Updated at Fri, May 29 at 07:34Source : 

By: Sandip Bhagat, Rajat Sethi, Vivek Kumar of S&R Associates

In a recent judgment issued on May 8, 2015 in a summary suit (IDBI Trusteeship Services Ltd. vs. Hubtown Ltd.), a single Judge of the Bombay High Court stated that a transaction involving foreign direct investment (FDI) in a real estate company was a colourable device and part of an illegal structure that provided an assured return to the foreign investor and violated the FDI regulations in India.

The judgment was issued in relation to a summary suit and winding up proceedings filed by an Indian debenture trustee (plaintiff) against Hubtown (defendant) for a guarantee issued in favour of the plaintiff.

As background, in November 2009, a Dutch corporation (foreign investor) acquired equity shares and compulsorily convertible debentures (CCDs) issued by an Indian company, Vinca Developers (Vinca), for a total consideration of Rs.418 crore.  The equity shares comprised 10% of the equity share capital of Vinca and upon conversion of the CCDs, the foreign investor would hold approximately 99% shareholding in Vinca.  Until such conversion, Hubtown and its promoters held 90% of Vinca.

The subscription agreement required the Rs.418 crores received by Vinca to be immediately invested in Amazia Developers (Amazia) and Rubix Trading (Rubix), two wholly-owned subsidiaries of Vinca that were involved in the development of townships in India.

Vinca invested in optionally convertible debentures (OCDs) issued by Amazia and Rubix.  The OCDs had a fixed interest rate of 14.5% per annum.  An Indian debenture trustee was appointed and Hubtown issued a corporate guarantee to secure the liability arising under the OCDs.

In 2012, the debenture trustee issued default notices under the OCDs and thereafter invoked the guarantee.  Subsequently, it filed a summary suit and commenced winding-up proceedings against the guarantor for the recovery of dues under the OCDs.

The Court examined the facts and reached a prima facie conclusion that Vinca was only a nominal recipient of investment from the foreign investor.  Vinca itself was not involved in the development of townships and it was the two subsidiaries that were involved in such development.  The downstream investment by Vinca in its subsidiaries was contractually predetermined.  This investment was in the form of OCDs that gave an assured 14.5% return to Vinca.  Since the foreign investor could convert its CCDs into 99% shareholding in Vinca, in effect, the foreign investor would receive an assured return on its investment, which was not permitted under the FDI regulations.

The Court also noted that the FDI regulations only permit FDI by way of equity or compulsorily convertible instruments in Indian companies.  Accordingly, while the foreign investor could have directly invested in CCDs bearing interest of Amazia and Rubix, the amounts invested would be compulsorily required to be converted into equity shares of Amazia and Rubix and the foreign investor could not have required Amazia or Rubix to repay the amounts invested.

In this context, we note that the Foreign Investment Promotion Board (FIPB) has previously expressed the view that downstream investment by a “foreign owned or controlled company” is only permitted through equity or compulsorily convertible instruments and not through non-convertible or optionally convertible instruments.  This FIPB view was not specifically discussed in the judgement.

The Court, relying on the 2012 decision of the Supreme Court of India in Vodafone International Holdings BV v. Union of India, held that a transaction is required to be viewed as a whole and a dissecting approach should not be adopted.  Further, a device which was colourable in nature has to be ignored.  The structure was devised to circumvent the restrictions imposed by the FDI regulations.

The Court also looked into the aspect of benefiting from one’s own wrong.  The Court noted that the defendant was raising issues on FDI policy and the enforcement of the guarantee three years after the transaction.  However, it also noted that the debenture trustee was seeking the assistance of the Court to enforce recovery by the foreign investor of its investment amount and interest, in a transaction that was contrary to the provisions of the FDI regulations.  The Court stated that the debenture trustee could not seek the active assistance of the courts to achieve what the law prohibits or declares illegal.

As the Court was only required to consider at this stage whether Hubtown’s defence raised triable issues, the judgement expresses a prima facie view which will be tested at the stage of the final disposal of the suit.  However, the Court has analysed FDI issues.  This case does strengthen arguments of Indian companies seeking to argue against the enforcement of contracts that potentially violate the FDI regulations.  This Court appeared willing to take a view of the transaction as a whole and conclude that it is colourable or illegal.

[The views expressed are personal and do not constitute legal advice.]

The Firm Note: Here is the Bombay High Court judgment in the Hubtown case…


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