Cruz City ruling: ‘Option’ for downside protection

By Damini Bhalla and Gargi Bohra, Luthra & Luthra Law Offices

Delhi High Court in its recent decision in Cruz City v Unitech rejected Unitech’s objections to enforcement of an arbitral award. The dispute related to the put option exercised by Cruz City obligating Unitech to cause payment of certain sums stipulated under the shareholders’ agreement, due to a delay in the construction project in question beyond the prescribed time period.

Damini Bhalla Partner Luthra & Luthra Law Offices
Damini Bhalla
Luthra & Luthra
Law Offices

Unitech argued that enforcing the award would be contrary to the public policy of India as the payment involved would contravene the Foreign Exchange Management Act (FEMA) and the FEMA regulations, including the restriction on an exit with assured returns in optionality clauses.

On public policy as a ground for refusal of enforcement of a foreign award, the court held that contravention of a law, including FEMA, was insufficient, specifically in light of the 2015 amendment to the Arbitration and Conciliation Act. It held that “fundamental policy of Indian law” would only mean “fundamental and substratal legislative policy and not a provision of any enactment”.

The court distinguished the case of Renusagar v General Electric, in which the Supreme Court held that a violation of the Foreign Exchange Regulation Act (FERA) was contrary to the public policy of India, by drawing a distinction between FERA (which proscribed foreign exchange transactions) and FEMA (which permits all foreign account transactions subject to reasonable restrictions).

Gargi Bohra Associate Luthra & Luthra Law Offices
Gargi Bohra
Luthra & Luthra
Law Offices

On the issue of Cruz City’s put option violating FEMA and the FEMA regulations, the court held that the option was not an open-ended assured-exit option. It could only be exercised on a default in the commencement of the construction project and within a specified time period. Notably, the court took the view that the Reserve Bank of India (RBI) circular proscribing optionality clauses granting assured returns on foreign direct investment (FDI) would not apply to cases where a foreign investor bases its claim on breach of a contract.

Equity instruments containing an optionality clause without any option/right to exit at an assured price currently are recognized as FDI compliant. However, no distinction is made between optionality clauses providing a return higher than the investment at a predetermined exit price and optionality clauses with a predetermined exit price as a stop-loss mechanism in the event of a breach.

The court’s ruling has created such a distinction. On similar lines, the RBI in its bi-monthly monetary policy statement of 3 February 2015 had contemplated allowing put options at a price lower than the invested price and restricting assured returns only in the event that the assured price was a mechanism to guarantee a return on a hidden debt. However, the policy statement was not followed by a formal notification by the RBI.

The court also placed reliance on the fact that Unitech had previously made unambiguous representations under the contract to the effect that Unitech’s obligations were valid, legal and enforceable. Hence, it was held that it was not open for Unitech to plead that the investments made by Cruz City were in violation of the provisions of FEMA.

Interestingly, the court also held that the requirement of obtaining the RBI’s permission for a certain transaction could be addressed at a post-enforcement stage by making any remittance of funds outside the country conditional on the receipt of such permission. In the court’s view, this approach would strike a balance as the public policy consideration could be addressed without declining recognition of a foreign award. However, this observation is in contrast to the DoCoMo v Tata Sons decision on the aspect of a subsequent permission of the RBI for remittance of funds for enforcing the award. In that case it was held that the court’s decision would be enforceable as such and the RBI would be bound by the determination such that no further permission of the RBI would be required.

While the two rulings are contradictory to each other on the aspect of a subsequent RBI permission, it must be noted that contrary to the finding in the DoCoMo decision, under the current FEMA regime, the payment of damages is a “capital account transaction” for which a specific approval of the RBI is required.

Though both the Cruz City and the DoCoMo decisions are expected to be appealed, for now, they will help boost investor confidence in India. However, the stance taken by the regulators when the remittances are made and the view taken by the court in the event of an appeal remain to be seen.

Damini Bhalla is a partner and Gargi Bohra is an associate at Luthra & Luthra Law Offices. The views expressed here are personal. They are intended for general information purposes and are not a substitute for legal advice.

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