option contract

In this article, Akshita Rishi who is currently pursuing M.A. IN BUSINESS LAWS, from NUJS, Kolkata, discusses enforceability issues in Option Contract.

Introduction

Amongst most popular exit mechanisms in India and foreign countries, put option and call option are very important and commonly found in different types of transaction structures like private equity, angel investors, joint venture, venture capital. [1]

Let us try to understand option contract in layman’s language. There are two people Mr X and Mr Y. Mr X has right to sell predetermined number of securities to Mr Y at a certain agreed price on a future date which means that a put option is enjoyed by Mr X against Mr Y. In the same way, a call option enjoyed by Mr X against Mr Y means Mr X can compel Mr Y to sell predetermined number of securities to Mr X at a certain agreed price on a future date.

However, many disagreements and conflicts are there while enforcing these options under various circumstances which we will discuss in detail later in this article.

Let us first understand the basics of option contracts, types, it’s working, various investment strategies and much more

Option Trading Mechanism

An option is a contract between two parties in which the maker of the option (option writer) agrees to buy or sell a specified number of shares at later date for an agreed price (Strike Price) to the holder of the option (Option Buyer) on a due date and time, when and if the latter so desires, in consideration of a sum of money (Premium). The premium is the price which is required to be paid for purchase of right to buy or sell. [2]

It is important to note that the terms of contract allow only the holder to cancel the contract and not the maker of the contract.

Types Of Options

There are two types of options:

  1. Call option
  • It means that the investor has a right to buy
  • An investor will opt for call option if he is expecting that the market price will be higher than the strike price so that he can earn a difference which will be his profit.
  1. Put option
  • The investor has a right to sell
  • The investor selects put option if he is expecting the market price to be lower than the strike price in the coming days. The lower is the market price than the strike price, the higher will be the profit for the investor.

NOTE: An investor has the option to simultaneously exercise both, the call option and the put option if he is uncertain about the future market conditions. [6]

Let us understand this with an example

Call Option

  • Mr X purchased are lot of say Reliance May 3000 call and pays a premium amount of ₹ 250. At this point of time the share price was ₹ 2900. Now, in this situation if the spot exceeds ₹3250 i.e. 3000 call plus 250 premium , then he will exercise the option but if the spot price remains under ₹3250 on expiry then he will let the option expire i.e. he will not exercise the option.

Put option

  • In this case Mr X feels that the price per share will decrease, in say Reliance Ltd. So, he decides to buy company’s 1070 put having spot price of ₹1040 per share. He also pays a premium of ₹30 per share on 1000 shares i.e. total amounting to ₹30,000. Now, in this case if the spot falls below the spot price i.e. Rs1040, then Mr X will exercise the option but if the spot price remains above Rs1040 then he will not exercise the option and will let it expire.

Working of Option

 It is the right of the option buyers and not the obligation to buy (call) or sell (put) the stock or we can say future contract at a predetermined price before the 3rd Friday of their respective expiration month. [3]

Investment Strategies

  1. Straddle

It is a combination of one put option and one call option. In this case, the investor is insured with respect to any movement on either side and has 50% minimum sure shot opportunity to gain from either upmove or downmove.

  1. Strap

Combinations of one put and two calls is known as strap. Any investor opts for strap only if he is confident that the scrip price will change and there are more chances that it will go up and not down.

  1. Strip

It is a combination of 2 put options and are call option. In this case, the investor is confident that the scrip price is more likely to go down than go up.

Pre-requisites for option trading

Proper infrastructure and writer of option are the most important pre-requisites at the initial stage of option trading. Proper infrastructure implies that the institutional infrastructure must be developed. This will require the writers of the options, who are also the speculators willing to take risks, for great and higher rewards. They generally meet commitments and have sufficiently large resource base if the buyer of the option wants to exercise his right.

For successful functioning of options trading, the following are required: –

  1. Terms of contract

The terms of contract should be standardised as this will decrease the cost of transactions and will make the development of the secondary market in options easier.

  1. Selection of underlying assets

The selection of all the underlying assets should be careful. These selected securities must be registered and listed on all major stock exchange.

  1. Engagement of market makers

Majority of market- makers who possess sound financial base, are required to give trading in options on a regular basis.

  1. Setting up of clearing house

To collect fees from each buyer and to create guarantee fund for the insurance of future performance of all the contracts will require a competent, well organised and well planned clearing house. In case of default by a future party, the clearing house is liable to pay all the cost to carry out the contract.

  1. Establishment of a central market

Proper establishment of a central market necessarily want regulation, vigilance and price circulation.

Enforceability of call option and put options

These options are commonly found in commercial practical situations.

For Example: – As we know Alternative Investment funds (AIF) are created with a definite life cycle in which they are required to return the principal amount as well as all the return amount collected on their investment to the investors at the end of the tenure of AIF. Due to this reason, during formation of AIF, the exit mechanism is well taken care off in the shareholders agreement entered with portfolio companies and promoters. These mechanisms include, Initial Public Offerings, tag along and drag along rights, pervasive call and put options. These options are specifically directed against the promoters.

Regulatory Framework

The following take care of the rules and regulations with respect to the option trading in India. [1]

  1. The Securities and Exchange Board of India(SEBI)
  2. The Reserve Bank of India (RBI)
  3. The Ministry of Finance
  4. The Ministry of Corporate Affairs

The SEBI is responsible for following

  • Regulation and growth of securities and securities market
  • Protecting the interests of the investors.

Reserve Bank of India (RBI)

  • It is India’s Central bank which is responsible for all monetary policies which includes foreign exchange regulations.

 

Option Contracts: Enforceability Issues


Past scenario regarding the regulatory framework

Securities and Contracts Regulations Act, 1956 (SCRA) originally Prohibited option trading in securities (which defined to include puts and calls) calling these transactions as undesirable in securities. [4] This ban on options was discarded by government of India by 1995, but SEBI took a different way. According to SEBI, option trading is illegal because: –

  • These options do not capacitate as an authenticate derivative contract.

According to SEBI, derivative contracts cannot be traded through private contracts, but can only be traded on recognised stock exchanges.

  • The second reason was that, a privately contracted option which permits the contracted parties to execute a right to put or call at a specific future date does not qualify as a valid ‘spot delivery’ contract.

At first, government of India vide its notifications dated 27 June,1961 exempted specified contracts for pre-emption in Articles of Association of limited company, in promotion or in the collaboration agreements. But Government under Section 16 of the SCRA vide notification dated 27 June 1967 prohibited all types of contracts apart from spot delivery contracts in any security under SCRA. An amendment was made by SCRA in the year 2000 that any derivate contract, if settled outside the stock exchange, would be termed as invalid.

NOTE

Spot delivery contracts are those contracts in which the parties entered transfers money and share on the same day of contract. Therefore, according to SEBI, privately contracted options breach the SCRA provisions and also suggested that other than spot delivery, all other options are species of ‘deliveries’ which are not recognised under SCRA.

Relevant Case

Cairin- Vedanta deal and Diageo and United Spirits merger

In both cases, there was a lot of debate on the decision of SEBI to prohibit the use of call or put options in their contract. This problem arose due to a relevant section of the securities contracts (Regulation) Act, 1956 which gives an exclusive right to government, RBI or SEBI to ban certain contracts in securities. As discussed above, SEBI banned trading through options other than spot delivery and this notification thus had a significant impact on these contracts as well.

Important Points

  • An informal guidance was released in May 2011, which was issued to Vulcan Engineers Limited. In this case, SEBI clearly specified that no option contract would meet the basis or benchmark of a spot delivery contract under section 2 of the SCRA, and under Section 18A of SCRA. It will never be taken into consideration as a valid derivative contract.
  • SEBI further issued a notification on October 3, 2013 authorising validity to contracts which provide pre-emptive rights, tag along and drag along rights and call and put options.

While SEBI focuses on the regulation of securities market, RBI’s paradigm is of FDI i.e. Foreign Direct Investment into India.

The Initial concern of RBI is regarding the use of options in foreign investment by foreign investors which may lead to volatility. The reason behind this is outflow of foreign exchange. RBI has clearly stated the various instruments to be classified as FDI and debt with respect to various separate and rigorous rules. Fully, compulsorily and mandatorily convertible instruments into equity shares are covered under foreign direct investment and the other instruments are considered as debt as issued vide circular dated Jan 09,2014. This rule has been included by the Ministry of Commerce in a well-established way in its annual FDI policy.

However, the above-mentioned circular stated that any guarantee should not be provided to the investor at the time of withdrawal or exit but subject to certain conditions such as: –

  • Lock in period of minimum one year from the date of contract or agreement.
  • Buy-back of securities at the amount which was determined while exercising such option or at an existing price etc.

Relevant Cases

  1. Vodafone International Holdings Vs Union of India and Anr.

In this case, Supreme Court perceived that all the provisions included in investment agreements regarding pre-emptions or call/ put options etc. may administer and regulate the rights between the parties. These rights should be purely contractual and should be owned by the parties. It was also stated that if mentioned in the Article of Association, then the shares can be freely transferred in any manner.

  1. Nishkalp Investments and Trading Co. ltd vs Hinduja TMT Ltd.

In this case, Bombay High Court observed that a contingent contract is within the scope of SCRA and is also lawfully applicable under it. The problem with respect to this case was related to buy back agreement. In this case, there was repurchase of certain number of shares and these shares were unlisted on the stock exchanges by a certain agreed date.

Bombay high court concluded the contingent contract as invalid because the setup of buy back of shares as mentioned above, were not covered under the provisions of SCRA.

Option Contracts are different from forward contracts

Let us understand this with the help of a case: –

Stock exchange limited Vs SEBI

This case dealt with enforcement of option contracts in which Bombay High Court clearly stated that forward contracts are different from option contract and these forward contracts are prohibited under SCRA.

  1. Takeaways for arbitration

    According to various news reports, there were some major highlights in the case of “The Indian Government and Aluminium Refiner Sterlite”. Sterlite was to exercise option to call the Indian Government’s stake of 49% in Bharat Aluminium Company. The arbitral tribunal found that the above-mentioned options of Sterlite are opposed to the public policy of India. The reason behind this was violation of free transferability of shares of a public limited company under Company Law Act. Arbitral award though is not public but it is important to understand that this provision of transferability of shares is a matter of controversy under Indian law which gives rise to a serious question as to whether the shareholders of public company can bind themselves to relinquish their shareholder’s rights in a stipulated way. Thus, the arbitral awards which enforce options can always be challenged in our Indian courts on the basis of violation of Indian public policy. However, under certain cases arbitrators can grant interim relief in cases of call and put options. In exit related disputes, exit routes are seldom restricted only to options. The freezing of assets of the promoter company or of the investee company is one such example.

Current scenario regarding the regulatory framework

On 3rd October 2013, SEBI issued a notification in which it validated option contracts but with a condition that the title and the ownership of the underlying securities should be perpetually held for a minimum period of one year by the party selling it, from the date of entering in the contract. The contract will be settled by the actual delivery of those underlying securities. Earlier SEBI had a clear stance on the non-enforceability of option contracts but in this notification, it clearly mentioned that “nothing contained in this notification shall affect or validate any contract which has been entered into prior to the date of this notification”.

After the above notification, on 30th December 2013, the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident outside India) (Seventeenth Amendment) Regulations, 2013 (“Seventeenth Amendment”) notified on the pricing of optionality clauses. Soon after on 9th January 2014 RBI issued a circular which dealt with the pricing of optionality clauses. This seventh amendment if read with the circular meant that “shares or convertible debentures containing an optionality clause but without any option/right to exit at an assured price shall be reckoned as eligible instruments to be issued to a person resident outside India by an Indian company.” Thus, we can say that the above-mentioned amendment and circular is not applicable to “call option” which can be exercised by an Indian promoter or a put option which is bestowed with the Indian promoter but all this is not at all free from ambiguity.

This seventh amendment also mentions the procedure and conditions of pricing optionality clauses. In case of equity shares of unlimited company, the price of the options shall not exceed the amount concluded on the basis of Return on Equity derived on the latest audited balance sheet. Now, in case of dentures or preference shares options can be exercised on a price which is calculated as per any internationally accepted pricing methodology at the time of exit which is duly certified by a qualified chartered accountant or a merchant banker registered with SEBI. A principle which guides regarding convertibles state that there is no guaranteed exit price for non-investors at the time of making such agreement or investment and will exit at the current price prevailing at that time, however, lock in period should be taken care off.

The above stated circular and amendment also imposed a lock in period of one year from the date of allotment on such instruments. However, still a point of conflict persists as to whether this circular and amendment is applicable to foreign investors covered under Schedule 6 of the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident outside India) Regulations, 2000 (“FEMA 20”) is permitted to “acquire by purchase or otherwise or sell shares / convertible debentures/units or any other investment held in the IVCU or VCFs or Schemes/ Funds set up by the VCFs at a price that is mutually acceptable to the buyer and the seller / issuer”.

Conclusion

After understanding above mentioned cases, various provisions and amendments we can conclude that in case of pure private companies, the call option and put options will be enforceable as per RBI’s pricing guidelines reason being that the Securities Contract (Regulation) Act is not applicable to pure private companies and arbitral tribunals will confirm the same. In case of listed companies and public unlimited companies, various difficulties may arise in the process of enforcement of exchange options and the investors will explore various other exit routes. [5]

Also, we must note that SEBI (Alternative Investment Funds) Regulation, 2012 is silent on all permissible exit mode of portfolio companies which govern Alternative Investment Funds. If SEBI would have cleared the distinction between call and put option and derivative contracts and also would not have prohibited AIFs looking for exit options, our lot of confusion would have been solved.

However, after the introduction of amendments by RBI and notifications by SEBI, various investors have re-negotiated their option contracts so as to act in accordance with the regulatory framework. This is relevant and important because the existing put options are not protected by regulatory changes.

References

[1] Introduction, enforceability of call option, put option and regulatory framework –
Singapore International Arbitration Centre – http://www.siac.org.sg/2013-09-18-01-57-20/2013-09-22-00-27-02/articles/197-enforceability-of-put-and-call-options-in-india-in-the-current-regulatory-environment

[2] Option trading contracts, types of contract, investment strategies, Pre-requisites for option trading – Capital Market and Securities law book by Sangeet Kedia

[3] Google Search – https://www.google.co.in/?gfe_rd=cr&ei=-zbeWMmLKujs8AefxaDYCw&gws_rd=ssl#q=working+of+options+&*

[4] Economic times official website –

http://economictimes.indiatimes.com/markets/stocks/news/vedanta-cairn-merger-offer-sweetened-for-shareholders-nod/articleshow/53338804.cms ,

Samvad partners – http://www.samvadpartners.com/wp-content/uploads/2014/04/Option-Contracts-in-India_April-2014.pdf  ,

Ara law advocates and solicitors – http://www.mondaq.com/india/x/488800/Securities/Option+Contracts+Enforceability+Issues ,

Singapore International Arbitration Centre – http://www.siac.org.sg/2013-09-18-01-57-20/2013-09-22-00-27-02/articles/197-enforceability-of-put-and-call-options-in-india-in-the-current-regulatory-environment

[5] Samvad partners – http://www.samvadpartners.com/wp-content/uploads/2014/04/Option-Contracts-in-India_April-2014.pdf

Singapore International Arbitration Centre – http://www.siac.org.sg/2013-09-18-01-57-20/2013-09-22-00-27-02/articles/197-enforceability-of-put-and-call-options-in-india-in-the-current-regulatory-environment

[6] kotak securities official website – www.Kotaksecurities.com

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