Put and call options are customarily found in investment transactions, joint ventures and acquisitions. A “put option” is the right of a shareholder of a company to sell its shares to another person at a pre-agreed price. Conversely, a “call option” is the right of a person to purchase shares from an existing shareholder at a pre-agreed price.
In investment transactions, put options are accorded to investors as a fall-back exit mechanism, typically as a means of liquidating a portfolio investment where an IPO or strategic sale is not feasible.
Call options are often found in joint ventures and strategic acquisitions, and entitle the option-holder to acquire shares from the joint venture/strategic partner on the occurrence of identified events. Call options are also used as a means to resolve disputes or situations of deadlock where parties are no longer able to conduct business harmoniously.
In investment transactions, a call option is often constructed as a default or remedial right that permits an investor to acquire ownership of a portfolio company (usually at a discounted price), and consequently replace management if there is mismanagement of affairs.
In India, transfers of shares of companies are regulated primarily by the Companies Act. Options are also governed by the Securities Contracts (Regulation) Act, 1956 (SCRA) and notifications issued under the SCRA.
Until recently, there was no conclusive view on the enforceability of options as the SCRA and notifications have been the subject of inconsistent judicial and regulatory interpretation for years. Nonetheless, one would routinely find options in investment documentation despite enforcement risk.
A notification by the Securities and Exchange Board of India (SEBI) dated 3 October now permits any of the following contracts for sale or purchase of securities: (1) spot delivery contracts; (2) contracts for sale and purchase of securities or in derivatives that are in accordance with applicable securities regulations, stock exchange regulations and bye-laws; (3) pre-emption rights, including rights of first refusal or tag-along/drag-along rights in shareholders’ agreements or articles of association; and (4) options in shareholders’ agreements or articles of association for purchase or sale of securities where: (a) the transferor holds the underlying securities continuously for a period of at least one year from the date of the contract; (b) the consideration payable is in compliance with all applicable laws; and (c) settlement is to be by actual delivery of the underlying securities.
The notification rescinds a notification dated 1 March 2000 which permitted only spot delivery contracts and those entered into through the stock exchange mechanism.
All contracts permitted under the 2013 notification must comply with exchange control regulations. This specifically applies to options and pre-emption rights granted by or in favour of non-residents. Consequently, any transfer of securities between a resident and a non-resident pursuant to the exercise of any option or pre-emption right must comply with pricing guidelines as prescribed by the Reserve Bank of India. Non-resident investors, therefore, do not have complete commercial freedom as options and pre-emptive rights continue to be subject to regulatory constraints.
The notification does not prescribe any conditions on the permitted pre-emption contracts nor does it specify all the various pre-emptive rights that can be enforced.
The notification prescribes a one-year lock-in for holding of securities and also requires options to be physically settled by actual delivery. These conditions curb speculative activities, and should not affect options in investment transactions (which are settled by physically delivery of securities rather than through cash settlement).
Since the notification applies prospectively and does not “affect or validate any contract which has been entered into” prior to 3 October 2013, pre-emption and options contracts existing prior to that date will not be governed by the notification.
While past pre-emption and options contracts could, therefore, be deemed unenforceable and may require re-execution as of a future date, a 1961 central government notification (which continues to be in force) provides that the SCRA does not apply to pre-emption or similar rights contained in promotion or collaboration agreements. Since options are similar to pre-emption rights, it would be reasonable to expect that options in earlier joint venture or collaboration agreements should be covered under the 1961 notification and should, therefore, fall outside the purview of the SCRA.
In the absence of sufficient clarity on this, a progressive and practical approach would be to apply the 1961 notification to past pre-emption and options contracts, and the 2013 notification to all such contracts executed on or after 3 October 2013.
Overall, the 2013 notification is a significant regulatory change. It rectifies a previously uncertain and convoluted legal regime, which intended to prevent speculative activities in securities, but impacted bona fide investment transactions by introducing inefficiencies in structuring exits.
Ganesh Prasad is a partner and Sharad Moudgal 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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