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No Assured Return!

Published on Fri, Jun 05,2015 | 22:19, Updated at Mon, Jun 08 at 18:04Source : CNBC-TV18 |   Watch Video :

The Assured Return chickens have come home to roost! Our top story this week maybe good news for Indian companies, but it’s every foreign investor’s nightmare!

Netherlands based foreign investor FMO wanted to invest in a slum rehab project and an industrial park being developed by subsidiaries of real estate company Hubtown and it wanted an assured return on the investment. But RBI policy permits only foreign equity investment in such projects and does not permit assured returns. To enable FMO to circumvent RBI policy an intermediary company Vinca was set up – in which Hubtown owned 90% and FMO purchased 10%  and 3 CCDs for 418 crores – these CCDs were convertible within 60 months starting December 2009.  Upon their conversion FMO's stake in Vinca would increase to more 90%.

THE HUBTOWN STRUCTURE
VINCA
Hubtown: 90%
FMO: 10% + 3 CCDs = Rs 418 cr
            CCDs convertible in 60 months starting Dec 2009
            Conversion would result in stake increase to 90%
 VINCA
                Invested in Optionally Convertible Debentures               
                @ 14.5% issued by
 
RUBIX                                  AMAZIA
Slum Rehab                       Industrial
Project                                 Park

Hubtown guaranteed the OCDs
FMO had control over any decision regarding OCDs

Vinca used FMO's investment to purchase optionally convertible debentures yielding 14.5% per annum issued by 2 of its wholly owned subsidiaries – Rubix and Amazia – the companies developing the slum rehab project and the industrial park. This direct and indirect investment by FMO was guaranteed by Hubtown. Agreements were structured to give FMO control over any decision regarding the OCDs.

When the OCDs defaulted FMO asked for its money back but to no avail. It invoked the Hubtown guarantee and that failed too. Hubtown plain refused to return the money. It argued that ‘the structure was  and is not lawful and is opposed to public policy as it was designed to defeat and would defeat the provisions of law, the FEMA regulations read with FDI policy’

Bombay High Court’s Justice Kathawalla agreed with Hubtown. He observed that

‘…interposing   Vinca   was   only   a   colourable   device designed   to   enable   FMO   to   claim   and   receive   back   its   FDI amount/investment and interest thereon at 14.5 % per annum.’

‘the complex structure devised for FMO’s FDI investment establishes that all parties were aware that the transaction which was premised on return back of the FDI amount along with a fixed rate of return thereon, was not permissible under/in violation of the FDI policy and the FEMA regulations.’

‘Neither   IDBI   nor   FMO     can   seek   the   assistance   of   the   court   to effectuate/implement/enforce such a prohibited/illegal transaction.’

To discuss the case, CNBC-TV18’s Menaka Doshi is joined by Abhijit Joshi of Veritas Legal and Sandip Bhagat of S&R.

Doshi: I want to get done with the technicality of the value of this decision first simply because this is not a final order. It is a summary order if I can put it that way or an interim one, so what would you say about the binding nature of this order and therefore how it would apply let’s say to similar structures?

Bhagat: The judge at this stage was simply making a determination whether or not there are issues here which are trialable and whether the defendant has raised enough issues to go for trial and the judge expressed a view on the structure, etc. but ultimately concluded that, look this can and this is a case where the defense has raised issues and there are issues here which need to go to trial. So, ultimately there will be a full hearing about this and these are observations which the judge has made and whether or not subsequently court determines to look into this or not is going to be entirely at its discretion.

Doshi: So, whether the outcome of the trial is similar to the observations by Justice Kathawala, none of us can tell therefore how much- I wouldn’t say importance because of course it is a judge saying what he is but what would the binding value of this be? What would this mean for other structures?

Bhagat: Persuasive but not really binding.

Joshi: It is an interesting question because while the judge has actually given prima facie views, he has agreed with Hubtown that it is illegal and uninforceable. He says this has to be tried within one year. Having said that, completely oblivious of the fact that the regulator may pick it up because the observations are though prima facie quite clear and may start its own investigation. So, in that sense binding or not binding but it is damaging and therefore we will have to see whether an appeal is preferred, whether any application is made…

Doshi: An appeal this interim or summary judgement if I can call it that?

Joshi: Yes, that is one and two, when an application is made to strike down these observations pending trial because the regulator may pick it up, they may not lay low for five years and say that we will wait till the trial, until such time we will ignore the observations of the judge which are quite clear.

Doshi: We have known for a long time now that assured returns are not permitted when it comes to Foreign Direct Investment (FDI). So, if a court is reiterating RBI’s policy, there is nothing really surprising about that, it is simply just saying this is what the law is or the regulation is but it is interesting how Justice Kathawala has looked at the series of transactions first in Vinca and then the subsequent investments in the downstream subsidiaries and said that at this point in time if you are asking for your money back, that amounts to an assured return and therefore that cannot be permitted. Would you agree with his assessment of the transaction in itself, the fact that there is a colourable device being used and the fact that this amounts to something illegal?

Joshi: If the facts have to be viewed, it is a 2009 case- that time the evolution of downstream investment and the policies on that were evolving, the evolution of owned and controlled foreign entities and therefore whether Indian entities…

Doshi: Was very new if I remember the press notes 2,3,4,5, I can’t remember if it was before or after the press conference.

Joshi: Very new or may not have even been there. So, the facts has to be tested as the laws stood then. If you take the law now, there is a lot of clarity on the subject and it has culminated in the judgement.

Bhagat: What is interesting here is the judge has stepped back and looked at the transaction as a whole and said, wait a minute, I am going through all of this and saying, based on this there is a assured return. Now, one of the pieces here is the fact that and an Indian company has invested in optionally convertible debenture (OCDs) of another Indian company and where is the assured return to the foreigner coming in there?

THE HUBTOWN STRUCTURE
VINCA
                Invested in Optionally Convertible Debentures               
                @ 14.5% issued by
 
RUBIX                                  AMAZIA
Slum Rehab                       Industrial
Project                                 Park

Hubtown guaranteed the OCDs
FMO had control over any decision regarding OCDs

As Abhijeet mentioned, over time and certainly today if you ask me, can a Indian company which is foreign owned or controlled, invest in OCDs, I would caution and say no, I don’t believe it is appropriate and it is certainly not something which the Foreign Investment Promotion Board (FIPB) would view favourably. At that point in 2009 there were different views out there, so that is one thing and the second thing even if the Indian entity itself is it really- ultimately its equity share capital was 10 percent owned by a foreigner and 90 percent owned by residents in India but there were compulsorily convertible debentures (CCDs) out there which gave the foreign owner effectively 99 percent. Again at that point you had to test it, figure out in 2009 what were people thinking about…

THE HUBTOWN STRUCTURE
VINCA
Hubtown: 90%
FMO: 10% + 3 CCDs = Rs 418 cr
            CCDs convertible in 60 months starting Dec 2009
            Conversion would result in stake increase to 90%

Doshi: If you had to sit in judgement of this in 2009, would you say that this is an unlawful structure?

Bhagat: If you are looking at what happened in 2009, at that point it would be debatable I would say. It wasn’t clear and you could see people taking a view that it is an investment by a company into another Indian company and so it is in the form of OCDs, we don’t think that is talking about- you are not looking through the whole structure.

Doshi: You said looking through the structure and that is interesting because that is exactly what the judge has done. He has used the Vodafone Supreme Court decision to say you have got to look at the transaction in entirety. Again, I do not know, on appeal how would a court look at the fact that they were looking at the transaction in entirety that the Justice came to the conclusion that Vinca is only a colourable device?

Joshi: It is a trialable question of fact and law and therefore it will be decided. But the fact is if you see it in entirety, certainly it looks a little bit close to the wind. But it will be dissected on segment by segment. Is it an owned and controlled company? So, while the judgement traverses upon it, it does not pronounce on it because today it is only 10 percent. 99 percent is on conversion. Then there is two to board, then there is veto item because if it a clear Indian owned and controlled company then you have to view the downstream investment in that context.

Doshi: As Indian, in that sense, right?

Joshi: So, there are a lot of aspects of this fact pattern which will be analysed on the segment.

Doshi: Which will be emerge only in trial, when it gets into detail arguments.

Joshi: So, if you sit back and look at the entire thing, you can say there is, you should question it at least.

Bhagat: When you look at what the Judge was doing, looking at it overall quoting Vodafone, it is certainly something to pause and people should be looking back and try to say what we have done in the past, is somebody going to be able to pierce through everything and take a conclusion that this, just on the feel of it, based on all these facts, you may have individually been fined, but overall this is what is happening. It is certainly of concern now.

Joshi: But, the principle is not new. What this tells us and all the investigations that have happened prior to different spheres tell us that now, probably, the time has come where we look at the law and in words and in spirit.

Doshi: There are several dozen such structures, and I am sure that is not a lawyer in this country who can literally say that I have not suggested such a structure to a foreign investor in representing a promoter. It is very difficult to bat for any of these questionable structures or colourable devices even if you are amazed of the fact that here is an Indian Company saying look I am arguing in court that I raised funds in an illegal way.

Bhagat: If ultimately you are looking at defence in terms of a whether it is in this case payment of money and that is a valid defence. A court can look at it and say yes I agree which it has then wouldn't you has an Indian Company raise it. You are getting into right wrong.

Doshi: I am not getting into right wrong I am just amazed. Here is Hubtown who raised this money Rs 418 crore in 2009, designed this structure, gave the foreign investor all the rights they wanted to and today is arguing in Bombay High Court saying I won't return the money because the structure is illegal. They are not the only ones to do this. There is a common joke on Call & Put options saying every time a foreign investor exercises a Put the Indian promoters calls RBI and says look is this allowed or not, right? So I am just saying.

Joshi: I think we are jumping the gun because we are also extrapolating out of the judgment. The judgment also talks about a Videocon case where it clearly says that you can not take advantage of your own wrong doing. It is not held, so therefore it is a trialable issue. All these issues will be gone at the time of trial and the question whether one can raise a defence something which as Sandip Bhagat said both parties new about is a question at large just now.

THE HUBTOWN STRUCTURE
'Assuming that Videocon have committed any wrong in issuing the Patronage  Letter without obtaining permission of the Reserve Bank, as per the settled legal position, it is not open to a party to take advantage of its own wrong.'

-    Bombay High Court Division Bench
July 2014

Doshi: I am sure there are dozens of companies that are doing pretty much a same thing to their foreign investors so this is going to be a closely watched case.

 
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