The Bombay High Court issued its ruling in IDBI Trusteeship Services Ltd. v. Hubtown Ltd., in relation to a foreign investment structure that involved compulsory convertible debentures (CCDs) issued by an Indian company to a foreign investor, the proceeds of which were in turn used by the Indian company to invest in optionally convertible debentures (OPCDs) of two wholly owned subsidiaries operating in the construction and development sector. 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.

In November 2009, a Netherlandcorporation NederlandseFinancierings – Maatschappiji Voor Ontwikkelingslanden N.V. (“FMO”) (foreign investor) acquired equity shares and subscribed to CCDs issued by an Indian company, Vinca Developers (Vinca), for a total consideration of INR 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 investment made by FMO in Vinca in the form of three CCDs was used by Vinca to purchase OPCDs issued by Amazia Developers Pvt. Ltd. (Amazia) and Rubix Trading Pvt. Ltd. (Rubix), two wholly-owned subsidiaries of Vinca that were involved in the development of townships in India. The OPCDs had a fixed interest rate of 14.5% per annum and Hubtownhad issued a corporate guarantee to secure the liability arising under the OCDs. In 2012, the debenture trustee invoked the guarantee for default of OPCDs by Amazia and Rubix. Subsequently, it filed a summary suit and commenced winding-up proceedings against the guarantor for the recovery of dues under the OPCDs.

The defendants challenged the invocation of guarantee inter-alia on the grounds that enforcing of guarantee is against public policy as the guarantee was for a downstream investment which was against the laws of India, FDI Policy and  FEMA regulations.

The Bombay High Court held that the transaction 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. While rendering the judgement, the Court did not accept the argument of the Defendant that 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.

Source: Bombay High Court, Ordinary Original Civil Jurisdiction, Summons for Judgment No. 39 of 2013, in Summary Suit No. 520 of 2013

VA View

This judgement should caution the foreign investors, who try to circumvent the FEMA regulations, which do not permit assured returns to equity investors, by adopting colourable devices. In such a case the Courts will view the transaction as a whole by transcending beyond the form and into the substance.