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
nidhi@vinodkothari.com
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.
(Concluded)

– Nidhi Bothra



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

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.

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