Thursday, January 23, 2014

Guest Post: Rights of MBS Bondholders Against the Company: Part 2

[The following post is contributed by Nidhi Bothra of Vinod Kothari & Company. The author may be contacted at

This is continuation of a previous post accessible here]

Does a trust put complete cloak over the identity of beneficiaries?

In the several rulings discussed in the preivous post, the privity of contract between the bondholders / debenture holders has been put to question. The rights of the debenture holders and the obligations of the company have been determined in terms of the agreement to the tee and not on the basis of equity or law. Before we delve into the question in details we need to understand the need for a trustee and the role conferred on such trustees in issuance of such instruments.

A debenture is a capital market instrument and it is commonplace for the beneficiary debenture holders put their trust in the appointed trustee to protect the interest of the debenture holders at all times. A debenture trust deed creates an express trust and the property is vested in the trustees and the trustee holds such property in trust for the benefit of the beneficiary. The arrangement renders logistical convenience to the issuer and the debenture holders as each time the debentures would change hands the security interest will have to be modified accordingly affecting the transferability of the instrument. If security interest is held by the trustee, the trustee can act expeditiously and effectively in safeguarding the interests of the debenture-holders; and enforcing the security on their behalf.
In some cases, the locus standi of the debenture holders has been questioned, on the ground that the company enters into covenants with the debenture trustees, and not with the debenture holders.

Thus, in Uruguay Central and Hygueritas Railway Co. of Monte Video, In re [1879] 11 Ch 372, the company had issued bonds or debentures and had created a debenture stock. There was no direct covenant between the company and the debenture stock-holders for payment of any amount to the stock-holders. The covenant was between the company and the trustees for payment of the amounts. The court held that in view of the terms of the deed, the holders of bonds were not creditors of the company; they were merely cestui que trust of a charge, having a right, no doubt, to put their trustees in motion to compel payment under the covenant, but not having any independent right to sue the company either at law or in equity.

Similarly, in Dunderland Iron Ore Co. Ltd., In re [1909] 1 Ch 446, a trust deed for securing debenture stock made between the company and the trustees for the stock-holders, provided that the company would pay the interest to the stock-holders. But the certificate delivered to each stock-holder did not contain any direct covenant with the stock-holder to pay him interest. It was held that stock-holders whose interest was in arrears were not entitled to present a winding-up petition as creditors under section 82 of the English Companies Act, 1862.

In both these cases, a debenture holder was held not to be a creditor of the company on the basis of covenants contained in the debenture certificate which was issued to him by the company. There are a number of cases, however, where English courts have construed the debenture holder as a creditor of the company wherever there has been such a direct covenant between the company and the debenture-holder.

In Olathe Silver Mining Co., In re [1884] 27 Ch 278, the earlier decision in Uruguay Central and Hygueritas Railway of Monte Video, In re [1879] 11 Ch 372 was distinguished. Looking to the covenants contained in the debenture certificate, the holder of the debenture in that case to whom interest was overdue was held entitled to petition for the winding-up of the company.

In the case of Bachharaj Factories Ltd. v. Hirjee Mills Ltd. [1955] 25 Comp Cas 227, a Division Bench of this court distinguished the case of Dunderland Iron Ore Co. Ltd., In re [1909] 1 Ch 446 and held that in the case before the Division Bench, there were debentures and not stock certificates. The debentures contained a personal covenant by the mills to pay to the debenture-holders. Hence the circumstances which prevailed upon the court in Dunderland Iron Ore Co. Ltd., In re [1909] 1 Ch 446 were not present in the case before them and the debenture-holder was entitled to present a winding-up petition as a creditor of the company.

In a later case of Sholapur Spg. and Wvg. Co. Ltd.[1], the court had held that a winding-up petition by a debenture-holder was maintainable in view of the direct covenant contained in the debenture certificates between the company and the debenture-holder to pay the amount to the debenture-holder, although in that case one of the relevant conditions was to the effect that the debenture was issued subject to the provisions of the trust deed whereby all remedies for the recovery of the principal money and interest secured by the debenture were vested in the trustees on behalf of the shareholders.

In the eyes of equity

The intent of the covenants of the trust deed irrespective of the provisions spelt out is to confer certain rights on the trustees for the benefit of the debenture holders not to refrain those rights from the debenture holders which originally would have vested in them in absence of the trustee acting on behalf of the debenture holders. Although certain rights may be conferred on the trustees and the debenture holders may not be direct party to such rights but as beneficiaries their entitlement to such rights cannot be denied in equity.

Similarly in the above judicial pronouncements the purpose of the bar on the debenture holders/ bondholders was to ensure that an individual bondholder did not jeopardise the benefit of all the bondholders and that a single trustee may act on behalf of the wider and common interest of all bondholders.

In the case of M. C. Chacko vs. State Bank of Travancore[2], the Supreme Court has observed as follows (at page 508) :

"... It has, however, been recognised that where a trust is created by a contract, a beneficiary may enforce the rights which the trust so created has given him. The basis of that rule is that though he is not a party to the contract, his rights are equitable and not contractual. The Judicial Committee applied that rule to an Indian case Khwaja Muhammad Khan v. Husaini Begum [1910] 37 IA 152; [1910] ILR 31 All 410. ... It must, therefore, be taken as well settled that except in the case of a beneficiary under a trust created by a contract or in the case of a family arrangement, no right may be enforce by a person who is not a party to the contract."

The right of the bondholder may be barred for logistical convenience but not in equity.


Can the beneficiaries proceed against the trustee?

The Indian Trust Act, 1882 explicitly lays down the rights of the beneficiary. The trustee is bound to fulfil the purpose of the trust and he must deal with the trust property as a man of ordinary prudence would deal with such property as if it were his own. The trustee is also bound to maintain and defend all such suits and take such other steps as may be reasonably requisite to preserve the trust property and assert or protect the title thereto (section 13 of the Act).

Under section 61 of the Trust Act the beneficiary has the right to compel the trustee to perform any particular act of his duty and restrained from committing any contemplated or probable breach of trust. Where there is a breach of trust the trustee shall be required to make good such loss which the trust property or the beneficiary have sustained (section 23 of the Act).

In light of the above, the debenture holders surely have the right to proceed against the trustees where it can be established that the trustees have acted in a manner jeopardizing the interest of the beneficiary or the trust property.


Future of such capital market instruments

The age old rule of substance over form must be relied upon for determining the rights of the bondholders.

The very essence of capital market instruments is free transferability of the securities. If the judicial pronouncements bar the rights of the bondholders based on the form, merely because the logistic convenience is acting as a hindrance for the bondholders to exercise their equitable rights surely does make a dent on their acceptability amongst investor classes. The more the complex instruments, the more such issues act as a hindrance on their acceptability. The judiciary may require the trustees to join any suit filed against the originator and/ or require other bondholders to join the class action, however merely on the pretext that the agreement explicitly rests this right on the trustee cannot deny the right of the bondholders on the equitable grounds. Hence the judiciary should remove the cloak and look at the substance of the transactions to render justice.


- Nidhi Bothra

[1] [1965] 35 Comp Cas 165
[2] AIR 1970 SC 504

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