There have been few court rulings offering interpretive guidance on the foreign direct investment (FDI) policy or the regulations under the Foreign Exchange Management Act, 1999 (FEMA). So the recent judgment of Bombay High Court in IDBI Trusteeship v Hubtown Ltd provides a welcome glimpse into the mind of the judiciary on matters related to FDI. The judgment considers the permissibility of structures that seek to circumvent the prohibitions under FEMA, in this case, on optionally convertible debentures (OCDs).
FMO, a Dutch development bank and a non-resident for the purposes of FEMA, invested substantial sums in two project vehicles of Hubtown, a real estate developer. The projects were an industrial park being set up by a company named Amazia, and a slum rehabilitation project in Mumbai by another company, Rubix. Amazia and Rubix were wholly owned subsidiaries of Vinca, a company promoted by Hubtown and other promoters. Vinca had its own FDI eligible township and construction projects.
FMO made investments in compulsorily convertible debentures (CCDs) issued by Vinca with the condition that the investment proceeds could not be retained by Vinca but were to be invested in OCDs issued by Amazia and Rubix. While CCDs, debt securities compulsorily convertible into equity shares of a company, are considered equity under FEMA, OCDs, being optionally convertible debt instruments, are not.
The CCDs in Vinca, when converted, would give FMO a 99% shareholding in Vinca. Under the documents executed by the parties, Hubtown guaranteed the repayment of OCDs and IDBI was appointed trustee to secure the OCD issuers’ obligations. The articles of Vinca were amended such that directors nominated by FMO on Vinca’s board alone would be entitled to take all decisions in relation to the OCDs.
The option to convert OCDs was not exercised and when called on to repay, Amazia and Rubix failed to honour their obligations. IDBI therefore invoked the guarantee issued by Hubtown and on Hubtown failing to make payment, filed summary suit for judgment against Hubtown. Hubtown’s main defence was that the FDI policy prohibits FDI through non-equity investments. FMO was aware of this prohibition and since it could not have invested in OCDs, Vinca was interposed as a “colourable device” and therefore the structure should not be enforced as being contrary to law, public policy and public interest.
IDBI countered that Vinca had its own FDI eligible projects and therefore the investment by FMO in Vinca was not in violation of the FDI policy, and that there was no bar on Vinca, an Indian company, investing funds in Amazia and Rubix in the form of OCDs. IDBI further contended that the doctrine of in pari delicto, which prevents a party that is complicit in entering into an illegal transaction from claiming relief, did not apply as Hubtown had induced FMO to make the investment by representing that the transaction was FDI/FEMA compliant.
The court, following the approach of the Supreme Court in Vodafone International Holdings BV v Union of India (2012), looked at the transaction as a whole rather than at its constituent elements, and held that facts suggested that Vinca was interposed as a colourable device and was only the nominal recipient of FDI, while the real recipients were Amazia and Rubix. The structure was designed to enable FMO to secure repayment of its investment with interest from Amazia and Rubix, contrary to the FDI policy and FEMA, and IDBI (through FMO) was seeking the assistance of the court to enforce a prohibited transaction.
The court agreed with Hubtown’s submission that once Amazia and Rubix had repaid Vinca’s investment amount with interest, FMO could either dissolve Vinca and receive the amount, or sell the shares of Vinca at a value which would necessarily include the benefit of the returned principal and interest.
The court inferred from FMO’s conduct in routing the investment through Vinca to Amazia and Rubix that it was aware of the prohibitions under FDI policy and FEMA and therefore it could not maintain that it was induced to make the investment by Hubtown’s representations as to the transaction being FEMA/FDI compliant.
While it may be true that by putting in place this structure, the investment amount and the return on it could be returned to Vinca intact, the judgment does not explain how this amount could have then been recovered by FMO without exposure to the equity risk from Vinca’s own projects, which would have impacted FMO in the event of a sale by it of the shares held in Vinca or realization of proceeds from dissolving Vinca.
The court did not delve into other issues (though some of these were vociferously argued by the parties) such as: Do restrictions on types of instruments and end-uses in FDI also apply to downstream investments by a company receiving FDI? And does ownership of convertibles, which when converted give the owner a majority shareholding, amount to “control”?
Luthra & Luthra Law Offices is a full-service law firm with offices in Delhi, Mumbai and Bangalore. William Vivian John is a partner and Hemant Krishna V is a senior associate at the firm. This article is intended for general informational purposes only and is not a substitute for legal advice. The views expressed are those of the authors and do not necessarily reflect the views of the firm.
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