Option clauses are often included in shareholders’ agreements to protect investors and provide exit opportunities. While put options give shareholders the right to sell securities, call options give them the right to buy securities.
The Securities Contracts (Regulation) Act, 1956 (SCRA) aimed to prevent undesirable securities transactions. It expressly prohibited options and contracts, permitting only spot delivery contracts and certain derivative contracts.
Although the SCRA was amended in 1995 to delete the proscription on options, in 2000 the Securities and Exchange Board of India (SEBI) prohibited forward contracts for the sale and purchase of securities and permitted only spot delivery and derivative contracts settled on a recognised stock exchange (2000 notification). This created ambiguity as to the validity of options.
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In 2013, the SEBI clarified matters by rescinding the 2000 notification and permitting the exercise of option clauses in shareholders’ agreements or articles of association (2013 notification). The 2013 notification provided that contracts entered into prior to 3 October 2013 were neither affected nor validated, applying therefore only to contracts executed after it came into force.
The 2013 notification came shortly after the decision in MCX Stock Exchange Limited v SEBI, in which the Bombay High Court (BHC) held that a put option agreement was distinct from a forward contract. The put option came into existence only when the option holder exercised their right. Despite MCX, uncertainty remained over the validity of put options prior to the 2013 notification.
Recently, the BHC, in Percept Finserve Pvt Ltd and Anr v Edelweiss Financial Services Limited, decided the legality of option clauses in contracts prior to the 2013 notification. Under a 2007 share purchase agreement (SPA), Edelweiss Financial Services (Edelweiss) purchased 228,374 shares of Percept from Percept Finserve Private (promoter) for INR200 million (USD2.4 million). If the promoter or Percept did not meet subsequent conditions, Edelweiss had the option either to resell the shares to the promoter at a price giving Edelweiss an internal rate of return of 10 per cent (put option) or continue to hold the shares of Percept subject to undertakings from the promoter. Edelweiss exercised the put option when the promoter and Percept failed to fulfil their obligations under the SPA. The parties invoked arbitration when the promoter refused to honour the put option.
Although the arbitrator held that the promoter and Percept had breached their obligations under the SPA, Edelweiss’s claim was rejected on the ground that the put option was illegal and in violation of the SCRA. The award was set aside by the BHC under section 34 of the Arbitration and Conciliation Act, 1996 (act).
On appeal under section 37 of the act, the promoter and Percept argued that the put option was a derivative contract as the purchase of shares was at a future date. As the purchase would be settled outside a recognised stock exchange, the put option contravened the 2000 notification, and was against public policy. They also contended that, as the 2013 notification applied prospectively, options entered into prior to 3 October 2013 were invalid.
The appellate bench of the BHC relied on MCX and held the put option was a contingent contract coming into existence only when the promoter and Percept failed to meet subsequent conditions and Edelweiss then exercised its option to sell the shares. The BHC held that the SCRA did not prohibit put option clauses but only regulated trading in derivatives. It further held that while an option gave a right to sell or purchase securities, there was no obligation to do so. The prohibition under the 2000 notification and the SCRA would only operate when the option was traded or dealt with. A contract was not a derivative contract merely because it contained a put option for securities, as option contracts were not prohibited. The appeal was dismissed with costs.
The judgment has settled the controversy over the validity of options concluded prior to 2013 and will provide comfort to investors looking to exit while managing risks. The imposition of costs will inhibit such litigation. Of course, from a business standpoint, parties must ensure that put option clauses are unambiguous and cannot be considered forward contracts.
Sneha Jaisingh is a partner and Anshul Singh is an associate at Bharucha & Partners
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