The past few years have witnessed sluggish primary market activity and few startups and mid-size companies have taken effective steps towards going public. In this environment, one of the typical exit strategies that assumes importance as a feasible exit option remains the put/call option.
The Securities and Exchange Board of India (SEBI) has historically objected to options as contravening the Securities Contracts (Regulation) Act, 1956 (SCRA), which permitted only spot delivery contracts. Initially, through a notification dated 27 June 1961, the government exempted specified contracts for pre-emption or similar rights contained in the promotion or collaboration agreements or in the articles of association of limited companies. Although options were not specifically mentioned, they could be implied to be similar to “pre-emption”. However, via a notification dated 27 June 1969, the government under section 16 of the SCRA prohibited all kinds of contracts except spot delivery contracts or contracts for cash or hand delivery or special delivery in any security under the SCRA. An amendment to the SCRA in 2000 provided that a derivative contract would be invalid if it was settled outside of a stock exchange.
SEBI prohibited the use of call/put options in the agreements for the Cairn and Vedanta merger and the Diageo and United Spirits merger. Further, in the informal guidance dated 23 May 2011 issued to Vulcan Engineers Limited, SEBI specified that an option contract would not meet the criteria of a spot delivery contract under section 2 of the SCRA and would also not be considered as a valid derivative contract under section 18A of the SCRA.
However, SEBI relaxed its position through a notification dated 3 October 2013, granting validity to contracts providing for pre-emptive rights, right of first offer, tag-along right, drag-along right, and call and put options.
The Department of Industrial Policy and Promotion (DIPP) in its FDI policy circular dated 30 September 2011 provided that equity instruments issued or transferred to non-residents having in-built options or supported by options sold by third parties would lose their equity character and would have to comply with the external commercial borrowing guidelines. This raised concerns for the regulators as the foreign investors were not taking genuine equity risks in Indian companies and instead seeking an exit at guaranteed prices (which classifies an investment as debt).
The DIPP’s stand attracted a lot of criticism from investors as such a provision affected genuine commercial transactions, where the foreign investor is provided an exit at the then prevailing fair market value. Accordingly, this provision was deleted through a press release on the 30 September 2011 circular, dated 31 October 2011. Later, the Reserve Bank of India via its circular dated 9 January 2014 permitted the issuance of equity shares, fully and mandatorily convertible preference shares and debentures containing an optionality clause. However, the circular specified that such an option/right should not provide a guaranteed return to an investor at the time of exit and subjected the option/right to conditions such as (i) minimum lock-in period of one year from the date of the agreement, and (ii) buyback of securities to be at a prevailing price or at a value determined at the time of exercise of such an option, etc.
The Supreme Court in Vodafone International Holdings v Union of India & Anr observed that the provisions for pre-emption rights, call/put options, etc., incorporated in investment agreements may regulate the rights between the parties which are purely contractual and such rights have efficacy only if such shares are owned by the parties. It was also held that the shares in a company are freely transferable in any manner subject to the articles of association of the company.
In the case of Niskalp Investments and Trading Co Ltd v Hinduja TMT Ltd Bombay High Court took a view that a contingent contract is within the scope and applicability of the SCRA. This case involved a buyback agreement to repurchase certain specified shares where the shares were not listed on the stock exchange by a certain agreed date. Bombay High Court held that a contingent contract for an arrangement of buyback of shares was subject to the provisions of the SCRA and was invalid in law.
The issue of enforceability of option contracts was further dealt with in MCX Stock Exchange Limited v SEBI, in which Bombay High Court cleared the air by holding that option contracts are different from forward contracts which are prohibited under the SCRA.
For a long period, companies and investors have been concerned about the enforceability of option contracts. The recent position taken by the Indian regulatory authorities is an investor-friendly step and in the right direction to boost investor appetite for Indian portfolio companies.
Rajesh Begur is the managing partner of ARA LAW, a ﬁrst-generation law ﬁrm with ofﬁces in Mumbai and Bengaluru. Prashaant Rajput is a senior associate at the ﬁrm.
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