The last few years have witnessed a sluggish primary market activity and very few start ups and mid-size companies have taken effective steps towards going public. In this background, one of the typical exit strategies that assumes importance as a feasible exit option remains the put/call option.
SEBI has historically objected to options as being in contravention to Securities Contracts (Regulation) Act, 1956 ("SCRA") which permitted only spot delivery contracts. Initially, the Government vide its notification dated June 27, 1961 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 there was no specific mention of "options", however the same could be implied to be similar to 'pre-emption'. However, vide a notification dated June 27, 1969, the Government under Section 16 of the SCRA prohibited all kinds of contracts except spot delivery contract or contract for cash or hand delivery or special delivery in any security under SCRA. The SCRA was amended in the year 2000 providing that a derivative contract would be invalid if they were settled outside the stock exchange.
In the case of Cairn and Vedanta merger and in Diageo and United Spirits merger, SEBI prohibited the use of call/put options in the agreements. Further, in the informal guidance dated May 23, 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 SCRA.
However, SEBI relaxed its position through a notification dated October 3, 2013 granting validity to contracts providing for preemptive rights, right of first offer, tag-along right, drag-along right, and call and put options.
The Department of Industrial Policy and Promotion ("DIPP") vide the FDI Policy (Circular 2 of 2011) dated September 30, 2011 provided that equity instruments issued/transferred to non-residents having in-built options or supported by options sold by third parties would lose their equity character and such instruments would have to comply with the extant External Commercial Borrowings (ECB) guidelines which 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 such investment as debt). This attracted a lot of criticism by the 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 vide Press Release on FDI Policy (Circular 2 of 2011) dated October 31, 2011. Later, the RBI vide its circular dated January 09, 2014, permitted 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 such investor at the time of exit subjected the same to conditions such as (i) minimum lock-in period of 1 year from the date of the agreement, (ii) buy-back 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 vs. 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 shall 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 such company.
In the case of Nishkalp Investments and Trading Co. Ltd. v. Hinduja TMT Ltd the Bombay High Court took a view that a contingent contract is within the scope and applicability of the SCRA. The question arose in this case was with respect to a buyback agreement to repurchase certain specified shares where the shares were not listed on the stock exchange by a certain agreed date. In this case, the Bombay High Court held that a contingent contract for an arrangement of buyback of shares is hit by the provisions of the SCRA is invalid in law.
The issue on enforceability of option contracts was further dealt with in MCX Stock Exchange Limited vs. SEBI, wherein the Bombay High Court cleared the air by holding that option contracts are different from forward contracts which are prohibited under SCRA.
For a long period, companies and investors have been concerned regarding the enforceability of option contracts. The aforesaid position taken by the Indian regulatory authorities is an investor friendly step and in the right direction that should surely boost investor appetite for Indian portfolio companies.
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