Enforcing put options as a method of investor exit

Much has been written about the enforceability of put options generally, and as a means of investor exit. The Securities and Exchange Board of India (SEBI) and Reserve Bank of India (RBI) have both questioned the enforceability of put options at different points in time but the enforceability of these instruments remains uncertain.

Joint venture and investment agreements often contain put option arrangements among shareholders. A put option contract is a key liquidity right for investors, and is often the only form of exit available for an investment in an unlisted company.

Early prohibitions

Enforceability of put options first came under the scanner when the Securities Contracts (Regulation) Act, 1956 (SCRA), prohibited options in securities and declared all such options to be illegal. This restriction was removed in 1995, reflecting the legislative intent to legalize options in securities. However, the 1995 amendment did not remove all ambiguities, as put options in securities became the subject of a legal debate on the sale and purchase of securities on a spot delivery basis.

By a notification in 1969, the central government made all contracts for sale and purchase of securities – other than spot delivery contracts or contracts settled through a stock exchange – void. In 2000, the government repealed the 1969 notification, but replaced it with a notification which was largely the same as the 1969 notification.

The 2000 notification also made illegal any contract for sale or purchase of securities other than a spot delivery contract or a contract for derivatives, among others. The 2000 notification and the 1995 amendment gave rise to conflicting positions on whether a put option contract for securities is legal and enforceable.

SEBI, in its response to a request by Vulcan Engineers under the SEBI Informal Guidance Scheme, took the view that since a put/call option is exercisable at a future date, it does not qualify as a spot delivery contract. SEBI has also stated that an over-the-counter put/call option does not qualify as “contract for derivatives” as it is not traded on a stock exchange and settled by the clearing house of a recognized stock exchange (which is how a derivatives contract is defined under section 18A of the SCRA). This position was reaffirmed by SEBI in the Cairn-Vedanta transaction.

Playing devil’s advocate

The position that a put option arrangement among shareholders is not a spot delivery contract, and is therefore illegal, fails to recognize two key aspects: (1) in a put option contract (as opposed to a forward contract), the contract for sale and delivery of securities comes into existence only when the option is exercised; and (2) the intent of the 2000 notification was to prevent undesirable speculation in securities.

In the context of a put option arrangement between shareholders, the intent is often to provide an investor with a liquidity right, and not to enable the investor to benefit from price movements in the underlying shares.

Bombay High Court, in a decision in March, recognized the distinction between an option and a contract for purchase and sale of securities. It held that while an option depends on the discretion of the person to whom it is granted, and its exercise cannot be compelled by the person who granted it, a contract for purchase and sale of securities is a reciprocal arrangement imposing obligations and benefits on the parties. The court noted that in an option, a concluded contract arises only upon exercise of the option.

The RBI’s view

The RBI has different concerns about put option arrangements. The RBI views put options by resident promoters in favour of non-resident investors as a way for an Indian promoter to guarantee principal protection and a pre-agreed return to a non-resident investor, which gives the equity investment the characteristics of a debt instrument. However, put options are often intended to give an investor a liquidity right, and so long as the exercise price of the option complies with the RBI pricing norms, a put option should not be held to be in violation of foreign direct investment rules.

Put option agreements are an important part of private equity investment transactions, and investors view the ability to exit as critical to their investments. Regulators have applied the law strictly without appreciating the nature of put option contracts among shareholders. The regulators need to re-examine this debate (particularly in light of the recent Bombay High Court decision) and recognize the importance of put option contracts to private equity investment transactions and joint venture arrangements among shareholders.

Shilpa Mankar Ahluwalia is a partner and Kushagra Priyadarshani is a senior associate at Amarchand & Mangaldas & Suresh A Shroff & Co. The views expressed in this article are those of the authors and do not reflect the position of the firm.