Option contracts have been an integral part of the Merger, Private Equity (PE) Deals in India since the liberalization of the Indian Economy. Indian corporate have been using options to structure their deals, raising finances from the foreign lenders. The foreign lenders entering in India want to secure their interest in the Company. In order to secure the interest, the common features which are seen in the Agreements and contracts are the pre-emption rights for the investor in the form of Right of First Refusal, Tag Along Rights, Drag Along Rights, etc.
Apart from the above, an important aspect for a foreign investor is the 'return' which it will get from the investment made in India. In case of unlisted companies, it has been generally seen that PE secures its exit through Initial Public Offering or the buy back of shares or the purchase of the equity investment of the Foreign Investor by the promoters. The Agreements are so designed that such Agreements provide a 'PUT' option to the Foreign Investor in order to secure the return on its investment. However, in some cases, the promoters also have a CALL/PUT option under which, promoters can buy out the stakes of the foreign investor at their option. Over the years the legality of the Options in the PE Agreements has been discussed by various forums. In India, the options transactions are regulated under the provisions of Securities Contract Regulation Act, 1956 (SEBI) and Securities Exchange Board of India Act, 1992 (SCRA).
SCRA & SEBI
The Regulator, SEBI has been of the strong view that the options are not a spot delivery contracts but Forward contracts. SEBI on various occasions has clarified that call options and put options are illegal because of the following two reasons
- Firstly, these contracts cannot be considered as valid derivative contracts as they can only be traded on stock exchanges and not through private contracts between parties.2
- Secondly, this privately contracted option gives the parties the right to put or call at a future date which makes it an invalid 'spot-delivery' contract under s.2 (i) of SCRA.
The SEBI in its informal guidance note given to Vulcan Engineers Ltd3 relating to the purchase and sale of shares of the company at a pre agreed price under the PUT/Call Options stated that:
'As [this] (put / call) option would be exercised in a future date...the transaction would not qualify as a spot delivery contract under SCRA S. 2(i), nor as a legal and valid derivative contract in terms of S. 18A.'
Also, in the Cairn-Vedanta deal4 SEBI was of the view that put option and call option arrangements and the Right of First Refusal do not conform to the requirements of a spot delivery contract nor with that of a contract of Derivatives as provided under section 18A of the Securities Contracts (Regulation) Act, 1956. Also, put option and call option arrangement along with the right of first refusal are in violation of Notification No. SO 184(E) dated March 1, 2000 issued by SEBI. SEBI in its view clearly provided that the Options not being the spot delivery contracts are prohibited in terms of SEBI Notification No. SO 184(E) dated March 1, 2000.
The SEBI Notification No. S.O 184(E) (1 March 2000) reads as "that no person in the territory to which the said Act extends, shall, save with the permission of the board, enter into any contract for 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 as is permissible under the said Act."
Bombay High Court in the case of Niskalp Investments & Trading v. Hinduja TMT Ltd5, held that "an agreement for buying back the shares of a company in the event of certain defaults was hit by the definition of spot-delivery contract under the SCRA and hence, unenforceable."
On the contrary, Bombay High Court in the case of MCX Stock Exchange Limited v. Securities & Exchange Board of India & Ors6 held as follows:
"In the case of an option, a concluded contract for purchase or repurchase arises only upon the exercise of the option. Under the notification that has been issued under the SCRA, a contract for the sale or purchase of securities has to be a spot delivery contract or a contract for cash or hand delivery or special delivery. In the present case, the contract for sale or purchase of the securities would fructify only upon the exercise of the option ... in future. If the option were not to be exercised by them, no contract for sale or purchase of securities would come into existence. Moreover, if the option were to be exercised, there is nothing to indicate that the performance of the contract would be by anything other than by a spot delivery, cash or special delivery."
The Hon'ble Bombay High Court in MCX case (Supra) took the contrary view from the Judgment pronounced in Niskalp case (Supra). According to the Court, once a contract is arrived at upon the option being exercised, the contract would be fulfilled by spot delivery and would, therefore, not be unlawful. However, against the said order of the Hon'ble Bombay high Court, SEBI preferred an appeal before the Hon'ble Supreme Court of India. Hon'ble Supreme Court of India in such appeal held that it is needless to say, in making amendments in the Regulation, SEBI shall not be bound by any observations or comments made by the High Court in the impugned judgment.
Reserve Bank of India
The Reserve Bank of India (RBI) has also raised its concern for the usage of put and call options on various occasions. According to RBI an investment made by a foreign investor which is backed by a put option at a pre-decided internal rate of return can neither be considered as an equity investment nor as a foreign direct investment, but is instead a debt investment. The reason behind this is that it is a guaranteed exit at a guaranteed price which according to RBI is equivalent to an external commercial borrowing.7
Also, in case the fixed return is offered on an equity instrument, such instrument would lose its character as equity and may be classified as debt.
Recently the Law Minister of India has cleared the position as to the options in the Private Equity and Merger deals in India. The Law Ministry has cleared the proposal for approval of the options in the agreements of the PE deals in India. Once notified, Indian Companies would be able to use options to structure mergers & acquisitions and PE arrangements. The said move is anticipated to render peace of mind to the foreign investors looking for such options in their transactions and it is also expected to encourage the foreign investors to enter in India and seek the agreeable returns.
In the light of the recent development, once notified, it would be clear that the matter of CALL/PUT options under M&A and PE Deals would be free from judicial controversy. The only aspect to look forward is that whether the said change when enacted would be applicable prospectively or retrospectively. In both the cases, there would be challenges and opportunities for the companies as well as investors. Also, a very important aspect of Foreign exchange management act, 1999 would have to be considered as allowing the change might also require the change ion the Foreign exchange management laws in order to differentiate the character of equity from debt.
2. S. 18A, Securities Contracts (Regulations) Act (1956).
3. Available at http://www.sebi.gov.in/informalguide/Vulcan/sebilettervulcan.pdf .
4. Available at http://www.sebi.gov.in/takeover/cairnlof.pdf .
5. (2008) 143 CompCas 2004 (BOM)
6. 2012 (114) BomLR 1002
7. Corporate exits, Queuing up to leave, India Business Law Journal, 20 (July/August 2012).
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