Enforceability of put options

By Sandip Bhagat and Jabarati Chandra, S&R Associates
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Foreign investors typically include exit options in transaction agreements that govern their investment in Indian companies. One such exit option is a put option. By this a foreign investor retains the right, but is not under an obligation, to sell the shares it holds to another person in India, usually the Indian promoter (the controlling shareholder), at a price that gives it an internal rate of return on the investment. The government of India no longer views such options favorably. There are also other company law issues to consider.

Equity or debt?

In its foreign direct investment (FDI) policy update effective 1 October, the government has stated that “only equity shares …. with no in-built options of any type, would qualify as eligible instruments for FDI” and 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 have to comply with the external commercial borrowing guidelines”.

Sandip Bhagat Partner S&R Associates
Sandip Bhagat
Partner
S&R Associates

The Reserve Bank of India (RBI) had raised objections to a put option being included in an agreement for an equity investment – whether or not the option has actually been exercised – as it gives a guaranteed rate of return that the RBI considered inappropriate for equity investments permitted under the “automatic route” of the foreign investment regulations. The RBI’s view was that if an investment includes a put option it should be considered similar to a debt investment and subject to more stringent regulation.

Investors need a degree of protection and liquidity on their investment and the government’s view creates more constraints on foreign investment. It applies to private and public companies.

The government ought to have considered that at the time of the sale of shares upon the put option exercise, the pricing guidelines need to be met and the Indian resident would not pay more than the fair value. However, the current policy update makes it clear that the government agrees with the RBI view.

Free transferability

There are additional issues to consider for put options, especially for a public company in India (which can be an unlisted or listed entity), that are relevant for non-resident and resident investors.

Section 111A of the Companies Act, 1956, provides that a public company’s shares should be “freely transferrable”. Some courts and regulators have held that although rights such as a put option may have been contractually agreed among the shareholders, they impose fetters on the free transferability of shares.

Jabarati Chandra Associate S&R Associates
Jabarati Chandra
Associate
S&R Associates

The Supreme Court has held that for a private company, such rights are enforceable if included in its articles of association. However, for a public company, certain courts hold that the articles of association cannot contain provisions that are contrary to the Companies Act.

There is an argument that a put option does not actually restrict transferability, but is rather an enabling right where the shareholders agree to the sale of shares at a future date. However, even if the put option is included in the articles of association, it may be unenforceable on the interpretation that it restricts free transferability of shares.

Spot delivery

The provisions of the Securities Contracts (Regulation) Act, 1956 (SCRA), are also relevant. The Securities and Exchange Board of India (SEBI) issued a notification in March 2000 prohibiting any contracts entered into without its permission for the sale or purchase of securities other than, inter alia, a “spot delivery contract” or a contract in derivatives permitted under the regulations. It defines a spot delivery contract as one that provides for actual delivery of securities and the payment for it either on the same day as the contract or the next day. According to the SEBI, including in its recent informal guidance, put options do not qualify as spot delivery contracts.

Although the March 2000 notification of the SEBI and the SCRA apply to all listed companies, certain judgments have extended the provisions of the SCRA to unlisted public companies. There is an argument that the settlement of an option is on a spot delivery basis and that the execution of an option agreement itself does not attract the SCRA as no actual delivery of securities takes place. There is also an argument that a put option is only a right and that a completed contract arises only if it is exercised. However, absent a clarification or amendment to the SCRA, it appears that a put option will not be permitted for listed companies and even for unlisted public companies, there is doubt on its enforceability under the SCRA.

Sandip Bhagat is a partner and Jabarati Chandra is an associate at S&R Associates, a law firm based in New Delhi and Mumbai. The views expressed above are those of the authors and not a substitute for legal advice.

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