In this blog post, Nabarun Roy, Superintendent of Central Excise and Customs, Export Refund Section, Central Excise, Kolkata – I Commissionerate, Kolkata under the Dept. of Revenue, Ministry of Finance, Government of India, who is currently pursuing a Diploma in Entrepreneurship Administration and Business Laws from NUJS, Kolkata, analyses the legal validity of put options in different types of companies as well as the latest developments in the field. 

Introduction

The enforceability of put options has always been a matter of debate with conflicting views on this subject. Securities Contracts (Regulation) Act, 1956 (hereinafter referred to as SCRA) under Section 20 originally sought for the prohibition of options in securities. In 1969 Government of India issued a notification in which under section 16 of the SCRA, all forward contracts in securities had been banned excepting ready forward transactions. Thereafter, the Government of India revoked the 1969 notification and delegated the powers to Reserve Bank of India under section 16 of the SCRA for regulating contracts in government securities, money market securities, gold-related securities, and derivatives based on these securities.

Further in June 1969, the Indian government issued a notification in which it was clearly mentioned that all contracts which include sale and purchase of securities other than spot delivery contracts or contracts settled through stock exchange are void. In 1995 Government of India omitted Section 20 of SCRA which states that options in securities shall be illegal and void. On such omission of section 20 of SCRA, Securities Exchange Board of India (SEBI) took a viewpoint that puts are illegal as these options do not qualify as valid derivative contracts and also as a valid spot delivery contract. Later in 2000, the 1969 notification was itself revoked, but it was mentioned that no person could enter into any contract for sale or purchase of securities other than spot delivery contract or contract for cash or hand delivery or special delivery. Thus again it raised the issue of enforceability of put options and in such circumstances SEBI took a view that such options did not qualify as spot delivery contracts under section 2(i) of SCRA and also did not qualify as legal and valid derivative contracts regarding Section 2(a) of SCRA.

Legal Provisions and Regulatory Bodies

In India, there are many legal provisions and regulatory bodies which are protecting the Indian securities market. Among these, the SEBI is responsible for regulation and growth of the securities market in India. RBI is responsible for the monetary policy which also includes foreign exchange regulation. The third body is Government of India, who administers the legal framework of put options. The main reason for opposing the put options given by the Reserve Bank of India (RBI) is that the use of these options is made by foreign investors in Indian market increasing the outflow of foreign exchange. Input option RBI has passed guidelines prohibiting the securities issued by the Special Purpose Vehicle (SPV) from having any put options provided either by the originator or by third parties. The RBI vide letter dated October 4, 2006, to the Indian Banks’ Association allowed third parties to provide put options. SEBI also did not consider put options as authenticated for a transaction of an asset as mentioned in the clause of the agreement made between private parties. Also in the past, SEBI asked contracting parties to delete these options from their agreements, including in the Cairn-Vedanta deal and more recently in the deal involving Diageo and UB Group’s United Spirits Ltd.

A put option provides a facility of exit from the investment to the investor from the company of investee before buyback or lock in period. Private equity investors make investments in all kinds of companies, including private firms and public limited companies whether such company is listed or unlisted. While the provisions of SCRA apply only to public limited companies whether such company is listed or unlisted but such provisions, do not apply to private limited companies. Therefore, any put option provided to a private equity investor for investment or for existing from such investment in a private limited company had no concern and would not be enforceable withstanding adverse views of SEBI regarding such options. Such kind of issue of enforceability of these options came up before the Hon’ble Bombay High Court in SEBI v MCX Stock Exchange case in which an order of SEBI was challenged. Three following issues were raised in this case,

1) Whether the buyback arrangements constituted a forward contract, which would be construed to be illegal;

(2) Whether SCRA was also applicable to unlisted public companies; and

(3) Whether the options violated section 18A of the SCRA as put options are not traded and settled through a stock exchange.

On the first issue, the court observed that a buyback would come into existence only at a future point in time on the date which is decided by the company to buy back the shares, in the eventuality of the party that is granted an option exercising it. Once such option is exercised, the contract would be concluded only by the spot delivery method or through another mode that is considered lawful. On the second issue, the court concurred that the SCRA would also be applied to unlisted public companies. Hon’ble Court refused to give its justification on the third issue by giving a reason that such issue is not cited on procedural grounds. SEBI filed an appeal against the order in the Hon’bleSupreme Court. In the apex court, the parties agreed to consent terms with SEBI stating that the view of the Hon’ble Bombay High Court is not binding on it. This diluted the decision of the Hon’ble Bombay High Court.

The SEBI has permitted Listed Companies to use put options as a clause in their contract agreement of sale and purchase of the share. It also provided rights to sell or purchase a security at a future date at a pre-determined price, in Merger and acquisition (M&A) transactions. SEBI has also allowed using other popular preferential clauses such as ‘right of first refusal, tag along and drag along. ‘A Right of first refusal in M&A is given to a body for the first right to purchase shares whenever they are offered for sale. Tag-along gives the right to a minority shareholder to sell its shares or not when a majority stakeholder shares are kept its stake for sells in the market, while drag-along clause forces a minority shareholder to its sell their shares with a majority shareholder. Many Experts also said that new norms approved by the law ministry would be beneficial for the both domestic and foreign corporate houses. The approved norms will also benefit institutional investors like Private Equity Investors and Foreign Institutional Investors (FIIs).The SEBI (Alternative Investment Funds) Regulations, 2012 which is a primary regulation to govern FIIs in India doesn’t provide any provision with regard to permissible modes of exits from portfolio companies.

Presently put options are valid subject to the following conditions:

1. No assured return or exit price can be guaranteed to the investor.
2. A minimum lock-in on foreigner’s shareholding of one year and more if a higher lock-in is prescribed under the FDI for certain sector, and
3. The new pricing guidelines of the RBI must be complied with.

The RBI pricing guidelines released in Jan’14 are as follows:

1. The price of equity shares must be capped by a specific method known as the return on the equity method.
2. Listed securities on which options are exercised will be transferred on the market price, and
3. The price of any convertible instruments must be arrived at in accordance with internationally accepted pricing methodology.

Though the put option is held as valid from the SEBI regulations perspective but the perspective of Companies Act, 1956 put options still suffered ambiguity. There was always a view from the companies Act perspective that the put option restricts the free transferability of shares in case of public companies and hence it should be considered as void. However, the Companies Act 2013 specifically permits enforcement of contracts for the transfer of securities privately amongst shareholders. Also, put options granted to foreigners could also lead to a violation of Foreign Exchange Management Act (FEMA). The FDI policy circular issued in 2011 of the government contained a clause stating that inbuilt options of investment transactions, which appeared to include put options are not permitted. However, the said clause was later withdrawn vide a corrigendum. Also, certain put options, which appear to promise a guaranteed rate of return, may be considered similar to debt and in which case, they will constitute External Commercial Borrowings (ECB) and will have to comply with the provisions of ECB regulations.

A major development has recently occurred from the law ministry in its proposal to hold put options valid. After such approval, the proposal will now go to the finance ministry, and if approved an amendment may be brought to the SEBI laws to hold that such put options are valid and enforceable. And this will also bring clarity to the enforcement of options and private equity investors will be able to enforce such options with complete certainty even in public companies irrespective of whether such company is listed or unlisted.