DOWNSIDE PROTECTION: NOT MERELY A LIP SERVICE ANYMORE

Indian courts are strongly heading towards an approach that

discourages Indian parties from using regulatory compliances as a

defense for resisting contractual obligations

Two judgments of the Delhi High Court this year

have caused a paradigm shift in our approach

towards investor protection. The Reserve Bank

of India (the RBI) has always maintained that

allowing a foreign investor to get a fixed or

assured return on its equity investment in India would

dilute the ‘risk’ factor, which is characteristic of an equity

instrument, and make it akin to debt. With this view,

the RBI traditionally opposed all kinds of optionality and

finally, in 2014, crystallized the law by validating option

contracts, albeit with a rider that a foreign investor cannot

be guaranteed an assured exit price. Despite the restriction,

exit options and pre-agreed returns on investments are, and

have always been, the pivot of investment deals. Indian

promoters, probably on the premise that the investor would

not be able to enforce such agreements, have been generous

in their promises to investors and do not shy away from

guaranteeing exits based on performance milestones and

other factors. The Delhi High Court has now ruled that the

Indian company and its promoters would be held to their

word, and protecting investment value is not merely a

theoretical right.

The judgments passed in the cases NTT DoCoMo Inc. v Tata

Sons Limited and Cruz City 1 Mauritius Holdings v Unitech

Limited are in the spirit of the current economic climate

and recognize that the need of the hour is to provide a

more conducive environment for foreign investments. The

rulings stress that contractual commitments be honored

and residents not be allowed to take cover under local law

to breach commercial agreements that they have entered

into with full knowledge of repercussions. A distinction has

been drawn between the times of FERA, where the focus was

to conserve foreign exchange, to the present-day endeavor

to reinvent India as a major investment destination. The

writing on the wall is clear – the defense of public policy

cannot be used to wriggle out of contractual obligations!

In the Cruz City case, Unitech Limited had guaranteed

purchase of Cruz City’s stake in Kerrush Investments Limited

(a joint venture between Cruz City and an associate company

of Unitech Limited)(Kerrush) by two associate companies of

Unitech, if Kerrush delayed a real estate project in India. A

dispute ensued when Cruz City exercised its put option and

the arbitral tribunal decided the matter in its favor. Unitech

challenged the arbitral award on grounds of public policy

stating that the proposed payment violated the provisions

of Indian exchange control regulations. However, the Delhi

High Court rejected Unitech’s contention and held that

“while violation of exchange control regulations is not

against the public policy of India, any remittance of the

money recovered from Unitech Limited under the arbitral

award would require compliance of regulatory provisions”.

The Court expected Unitech to fulfill its promises even if it

entailed obtaining regulatory approvals or suffering penal

consequences. The Court estopped Unitech from asserting a breach of FEMA after having provided unambiguous

representations to Cruz City regarding enforceability of its

obligations under the agreements.

In the DoCoMo case, while the Court did not directly delve

into the question of whether the transaction was in conflict

with public policy of India, it upheld DoCoMo’s right to

receive 50% of its original investment amount. In this case,

Tata was required to find a buyer for DoCoMo’s shares in

the event that it failed to satisfy certain pre-determined

performance parameters. The arbitral tribunal unanimously

ruled that Tata was liable to pay damages and recognized

that the parties had deliberately linked the exit provision

with breach of performance parameters, being aware that

exchange control regulations may prevent performance of a

simple put option. The Court upheld the award and rejected

the contention of the RBI that the payment from Tata to

DoCoMo was in the nature of an assured return.

These cases establish a very clear intent - violation of an

economic law to protect foreign exchange outflow is not

sufficient ground for declining the enforcement of a foreign

award on grounds of public policy. Indian parties should

honor their contractual commitments and should not be

permitted to hide behind their failure to obtain approvals

or the lack of gravity in making a promise which they could

later treat as illegal. A contrary stance would have certainly

affected the faith of foreign investors in the Indian legal

system.

It is pertinent to note that in both these cases, the foreign

arbitral awards were challenged. Under the Arbitration and

Conciliation Act, 1996 (the Arbitration Act), enforcement of

a foreign award can be challenged on substantial grounds if

it is contrary to the public policy of India. In such a scenario,

an interesting question that arises is whether the parties

challenging the arbitral award would have had a better case

if they had resorted to domestic arbitration. This is more

so in light of the recent amendment to the Arbitration Act,

which permits arbitral awards arising out of arbitrations,

other than international commercial arbitrations, to be set

aside if the court finds that the award is vitiated by patent

illegality appearing on the face of the award.

Patent illegality was brought within the ambit of public

policy by the Supreme Court in the case of Oil and Natural

Gas Corporation Limited v Saw Pipe Limited where it held

that “if the award is contrary to substantive provisions of

law or the provisions of the Act or against the terms of the

contract, it would be patently illegal”. However, based on

recommendations of the law commission and the judgment

of the Supreme Court in ShriLal Mahal v Progetto Grano Spa,

the legislators did not want the concept of patent illegality

to apply to foreign arbitral awards and therefore, decided to

limit the scope of the interpretation given to ‘public policy

of India’ and included ‘patent illegality’ as separate ground

to set aside domestic awards. Awards have been set aside

on the grounds of arbitrariness, irrationality or a perverse

understanding or misreading of the materials placed before

the arbitrator, or even in cases where the arbitrator has

awarded damages without the parties having proved the

losses suffered by it. The ambit of judicial intervention

has also been restricted by the amendment which states

that an award cannot be set aside merely on grounds of

an erroneous application of the law or by reappreciation of

evidence. This seems to indicate that the conclusion of the

Court may not have been very different even if the arbitral

awards in the DoCoMo case and the Cruz City case were

subjects of domestic arbitrations.

In conclusion, Indian courts are strongly heading towards

an approach that discourages Indian parties from

using regulatory compliances as a defense for resisting

contractual obligations. While such a stance in laudable

from an investor perspective, it urges Indian promoters to

look at their contractual commitments, specially around

exit provisions, with greater scrutiny. Investors are likely

to use these decisions to their advantage and incorporate

structures that will minimize the risk quotient in their equity

investment and at least ensure a downside protection. In

such cases, the Indian promoters may have very limited

opportunity to negotiate against such provisions. Therefore,

to adequately protect the Indian promoters against any

misuse of these provisions, contracts will need to be drafted

to ensure that the factors triggering exits are watertight and

not subjective or ambiguous. The parties, both the investor

and the promoter, need to be clear on what they have signed

up for because neither will be able to back out.

Disclaimer – The views expressed in this article are the personal views of the authors and are purely informative in nature