Option agreements in India

By Uday Walia and Brajendu Bhaskar, S&R Associates
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The law on options in securities in India is governed by the Securities Contracts (Regulation) Act, 1956, (SCRA) and rules and regulations framed under it. Foreign investors should be aware that Indian law on this subject may be different from the law in other common law jurisdictions and should factor this in while structuring transactions.

Uday Walia Partner S&R Associates
Uday Walia
Partner
S&R Associates

Does the law apply?

The SCRA applies to securities issued by a listed company and not to private limited companies, as shares of a private company are not freely marketable. There is, however, no consistent view on the SCRA’s applicability to shares of an unlisted public limited company. Calcutta High Court has held that the term “marketable securities” could not be restricted to securities traded on a stock exchange, and accordingly applies to shares of an unlisted public limited company since they are capable of being listed. However, Bombay High Court has observed that the SCRA was not intended to govern shares of an unlisted public limited company.

Accordingly until the Supreme Court settles the ambiguity in respect of the applicability of SCRA to unlisted public companies or it is clarified by statute, the issue remains contentious.

Allowing options

Options in securities were prohibited under section 20 of SCRA until it was deleted by the Securities Laws (Amendment) Act, 1995. However, SEBI issued a notification in March 2000 prohibiting any “contracts entered into without its permission, for the sale or purchase of securities other than such spot delivery contract or contract for cash or hand delivery or special delivery or contract in derivatives…”.

Consequently, if an option agreement is a contract for the sale or purchase of securities, it will be subject to the SEBI notification. The question, therefore, is whether the contract is for spot-delivery or derivatives, and therefore permitted.

Permitted contracts

Under section 2(i) of the SCRA a “spot delivery contract” is a contract which provides for actual delivery of securities, paid for either on the same day as the date of the contract or on the next day. While it is easy to provide that the settlement following the exercise of an option will be on a spot delivery basis, it may be difficult to make the case that the execution of an option agreement itself is a spot delivery contract as defined under the SCRA and consequently permissible. This is because there is no actual delivery of securities when the option agreement is executed.

However, it may be argued (relying on section 2(h)(iii) of SCRA) that an option grants the holder a “right or interest” in the securities, and consequently the execution of the agreement constitutes a delivery of such right or interest in the securities. However, whether the phrase “right or interest in securities” as used in section 2(h)(iii) of the SCRA refers only to a legal and equitable right or interest in such securities or also includes a contractual right to transfer such securities in future has not been settled by an Indian court.

Brajendu Bhaskar Associate S&R Associates
Brajendu Bhaskar
Associate
S&R Associates

Contract in derivatives

Arguably, an option agreement is a contract in derivatives and therefore permitted under the SCRA and the SEBI notification if it is (i) traded on a recognised stock exchange; and (ii) settled through the clearing house of that exchange.

Under section 2(ac) of the SCRA, a derivative is defined to include (A) a security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security; (B) a contract which derives its value from the prices, or index of prices, of underlying securities.

In Rajshree Sugars and Chemicals Limited v AXIS Bank Limited, Madras High Court observed that an option was a derivative instrument that gave the holder the right to buy or sell an underlying asset at a future date at a predetermined price.

In Rakhi Trading Private Limited v the SEBI, the Securities Appellate Tribunal has recognised options as a type of derivative contract and has observed that such contracts would only be valid if in accordance with section 18A of the SCRA, they are traded on a recognised stock exchange and settled through the clearing house of that exchange.

To conclude, while the legal position remains unclear, the conflicting judgments of various courts have only added to the ambiguity. In addition, SEBI has consistently taken the view that an option contract does not qualify as a spot delivery contract under the SCRA and is hence unenforceable.

Uday Walia is a partner and Brajendu Bhaskar is an associate at S&R Associates, a law firm based in New Delhi and Mumbai. They can be contacted at uwalia@snrlaw.in and bbhaskar@snrlaw.in respectively.

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