On 3 October 2013, the Securities and Exchange Board of India (SEBI) issued a notification permitting put and call options in certain transactions involving public listed companies. The SEBI notification put an end to the debate (that had ensued for the longest time) on whether contracts involving put and call options in a listed company are enforceable.
Despite the SEBI notification, much needed certainty from the Reserve Bank of India (RBI) had been lacking on the issue of put and call options – the RBI had at one point even considered fixed return linked options to be in the nature of debt and disallowed them. In a notification dated 12 November 2013 that was made publicly available only recently, the RBI has permitted non-residents to acquire Indian securities with “optionality”.
The RBI notification read with an RBI circular dated 9 January 2014 clarifies the RBI’s stand on call options, put options and other exit-linked terms for both listed and unlisted securities. However, this relaxation comes with certain limitations that are set out in brief below:
Assured returns: Non-residents cannot have assured returns on the securities as part of their exit mechanism. This appears to be the guiding principle.
Lock-in: Non-residents with such securities will be locked in for a period that is higher of: (i) one year from the allotment date; and (ii) sector-specific lock-in applicable under the foreign direct investment (FDI) policy.
Exit pricing: Exit by non-residents cannot be at a price that is higher than: (i) for listed securities, the market price determined on the floor of a recognized stock exchange; (ii) for unlisted securities that are equity shares, at a price to be arrived on the basis of “return on equity” (that is, profit after tax divided by net worth, in each case based on the latest audited balance sheet of the company); (iii) for unlisted securities that are compulsorily convertible preference shares or compulsorily convertible debentures, at a price arrived at by a chartered accountant or a SEBI-registered merchant banker (valuer), based on internationally accepted pricing methodology.
Though the RBI notification brings much needed certainty on some issues, it also throws up some new questions, for instance:
(a) Would these lock-in provisions be applicable on secondary shares (i.e. those that non-residents acquire from existing shareholders)?
(b) What was the necessity for a different exit price mechanism for equity shares and compulsorily convertible preference shares/debentures, when compulsorily convertible preference shares/debentures issued under the FDI policy are treated as equity?
(c) Would it be more beneficial for non-residents to continue to hold compulsorily convertible preference shares and compulsorily convertible debentures (instead of converting into equity shares) considering the exit price of such instruments is linked to a more subjective determination by a valuer?
(d) Would these rules also apply to investments made by foreign venture capital investors that enjoy a free-pricing regime?
Two pricing regimes
The FAQs available on the RBI website dealing with “Foreign Investments in India”, updated as of 28 January 2014, make it clear that there will be one pricing regime for securities without optionality, that is, existing ceiling and floor concepts of price computed in accordance with the discounted cash flow method (for unlisted companies) and SEBI rules to determine pricing (for listed companies); and a pricing regime for securities with optionality as has been set out above.
The FAQs further confirm that an exit price ceiling as set out above would also be applicable to listed securities which are sold by a non-resident in an off-market transaction.
Given this change in the legal landscape, it is clear that existing contracts containing options on Indian listed securities which pre-date 3 October 2013 are invalid unless re-executed as the SEBI notification, unlike the RBI notification, only blesses transactions following the date of the SEBI notification. Further, these developments should also be kept in mind while making downstream investments through foreign owned and controlled Indian companies. Such companies would also need to comply with the RBI notification while acquiring securities with optionality of other Indian companies.
Certain issues still need further clarity, however, the SEBI notification read with the RBI notification and the late request proviso to section 58(2) of the Companies Act, 2013, that recognizes the validity of shareholders’ agreements among shareholders, brings certainty in structuring transactions in India.
The next few months should bring further clarity on these open issues, but for the moment, we should appreciate the concerted effort of the Indian regulators to clear clouds over their stand on call and put options.
Aakash Choubey is a partner and Mayank Singh is a principal associate at Khaitan & Co. The views of the authors are personal, and should not be considered as those of the firm.
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