Tuesday, February 16, 2016

Supersession of Bond Terms by State Legislation Disallowed

In Kalyan Janta Sahakari Bank v. State of Gujarat, a division bench of the Gujarat High Court was concerned with whether a legislation passed by the Gujarat State Legislature can unilaterally alter the terms of an issue of bonds by the government company to the detriment of the bond investors. The Court answered in the negative by striking down the legislation on grounds of lack of legislative competence of the State Legislature. While the case was decided predominantly within realm of constitutional law, it has immense implications for securities regulation and protection of bond contract terms.

In 1994, the Sardar Sarovar Narmada Nigam Limited (SSNNL), a government company, issued deep discount bonds (DDBs) to various investors. Under the terms of the DDBs, they were issued at a deep discount of Rs. 3,600 per bond, which was redeemable at the face value of Rs. 1,11,000 at the end of 20 years. The prospectus also provided for a “put option” to the investors who could seek early redemption of the bonds at the end of the 7th, 11th and 15th years. Although there was no corresponding “call option” available with SSNNL under the prospectus, the same was introduced by the Gujarat State Legislature through its enactment of the Sardar Sarovar Narmada Nigam Limited (Conferment of Powers to Redeem Bonds) Act, 2008 (the “Act”). The Act carried out the role of inserting a new condition into the bond terms by which SSNNL was conferred the power to redeem the DDBs at a date prior to the expiry of their term. In other words, the bondholders were subjected to a call option available to SSNNL through subsequent legislation even though such an option was not available as part of the prospectus and bond terms that SSNNL and the bondholders had contractually agreed to. Moreover, the early redemption foisted upon the bondholders was on less favourable terms than if they had held on to the DDBs until the end of the original term as set out in the prospectus. The legislation had the effect of altering the contractual terms of the bonds without the consent of the bondholders who were a contracting party. The question arose as to whether such legislative supersession of bond terms was permissible under law.

After a detailed analysis of constitutional law, and particularly issues pertaining to legislative competence, the Gujarat High Court found that the state legislature lacked the competence to pass the legislation, which was held to be unconstitutional and was therefore struck down. The High Court found that the legislative competence was not traceable to any of the entries in the State List under the Constitution. Although it could arguably draw some source from matters in the Concurrent List, the Court found that in pith and substance it can be traced to matters in which Central laws are already in operation, including the Securities Contracts (Regulation) Act, 1956, the Securities and Exchange Board of India Act, 1992 and the Companies Act, 1956, as these provide for a framework for issue and trading of securities, including government securities of the present kind.

After holding the Act to be unconstitutional, the Court refused to grant any consequential relief to the bondholders. This was on the ground that such relief required the Court to go into evidentiary matters and also those relating to limitation and other legal considerations, which would be within the domain of a civil court. Hence, the affected bondholders’ remedies were stated to lie in a civil court before which they are to initiate proceedings. Moreover, the Court also stated that such recourse would be available to bondholders only if they had received early repayment from SSNNL under protest, and not otherwise. However, the Court stayed the operation of its judgment for eight weeks, and it has been reported that the bondholders are likely to initiate an appeal to the Supreme Court on account of their inability to obtain consequential relief from the Court.

This decision as well as the dispute that gave rise to it in the first place offer important lessons. First, it is one among several instances where contractual terms between parties, especially when one happens to be the state or a government company, are subsequently unilaterally altered to the detriment of a private counterparty. This occurs when the state enters into a contract that it subsequently finds carried terms that were unfavourable to it, and seeks to renege on that contract citing public interest. In the present case too, the preamble to the Act cited “public interest” as a ground for seeking the alter the terms of the DDBs because, due to declining interest rates, it became financially unviable for SSNNL to maintain the DDBs until the end of the original term. Ideally, a “call option” ought to have been set out in the terms of the prospectus so as to deal with such a situation. But, the Government sought to address such an inadequacy by subsequent legislation when it discovered that continuing with the bonds became financially untenable. The problem lies in the fact that such a decision is unilateral and does not include the consent of the counterparty, being the bondholders. At the same time, such issues are not novel, and do arise in the case of various types of government contracts, which often tend to end up in litigation like the present one. On this occasion, it was questions over legislative competence that came to the rescue of the bondholders.

Second, as for the High Court’s resistance to deciding on the merits of the various bondholders’ claims, that is perhaps understandable as it ought to be undertaken through a civil court. However, it appears from the news report cited above that the bondholders would like to seek consequential relief through the writ jurisdiction of the court given that a civil suit is likely to be beset by delays and costs.

Third, given that the High Court came to the conclusion that the individual claims of the bondholders must be asserted before a civil court, it is somewhat surprising that it has also sought to limit the type of claims that may be so asserted, in that only bondholders who have received payments in protest are entitled to do so. There does not seem to be any reasoning or rationale provided for the same. To that extent, the bondholders (whether or not they have protested) may be justified in making a claim for relief, particularly because the entire legislation was found to be unconstitutional. There is no reason why some bondholders’ rights become unavailable by virtue of a legislation that has been struck down to be unconstitutional.

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