How effective is the option to exit for foreign investor?

By Amit Kumar and Janani Sekhar, Amarchand Mangaldas
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Two important legal developments bear on the above question. Firstly, the long-standing debate regarding enforceability of “put” and “call” options in public companies has been put to rest with the enactment of the Companies Act, 2013 (2013 act) and a recent notification issued by the Securities and Exchange Board of India (SEBI) under the Securities Contracts (Regulation) Act, 1956 (SCRA). Secondly, the price at which options can be exercised has been codified by the Reserve Bank of India (RBI) in a circular dated 9 January 2014, which impacts the concept of assured returns that are often contractually guaranteed to foreign investors via put options.

Public companies

The Companies Act, 1956 (1956 act), provided for free transferability of shares of a public company and recognized the rights of private companies to restrict the transfer of their shares. The enforceability of put and call options in public companies however, became the subject of judicial analysis as such options were perceived to violate the provisions of the SCRA and notifications issued under it, as well as the right of free transferability of shares under the 1956 act.

Amit Kumar
Amit Kumar

The 2013 act has provided clarity in this regard by giving statutory recognition to the enforceability of any contract or arrangement between companies (including public companies) in relation to transfer of securities. Additionally, a SEBI notification dated 3 October 2013 has settled the decade-long legal debate on the enforceability of options in public companies, by permitting companies to prospectively enter into contracts in their articles of association or in shareholders agreements for purchase or sale of securities pursuant to exercise of put or call options, subject to certain conditions.

The notification also mandates that such contracts are to be in compliance with the provisions of the Foreign Exchange Management Act, 1999, and regulations under it.

Option exercise price

The grant of exit rights in the form of put options has also been shrouded with uncertainty from a foreign exchange control perspective. In 2010, the RBI mandated that any transfer of shares of an unlisted company between non-residents and residents would have to be at the fair market value computed by the discounted cash flow method. However, despite this pricing restriction, foreign investors were often contractually granted assured returns on exit via put options.

The RBI had, on a case-to-case basis, expressed reservations on the grant of such options as exit mechanisms on the ground that the guarantee of assured returns gave equity instruments a debt-like feature which facilitated an indirect circumvention of compliance with the external commercial borrowing guidelines.

The RBI has now codified its position on optionality clauses by permitting companies to issue shares or convertible debentures containing an optionality clause to foreign entities under the foreign direct investment (FDI) scheme. The optionality clause will oblige the buy-back of securities from the investor at the price prevailing or value determined at the time of exercise of the optionality so as enable the investor’s exit without any assured return.

Janani Sekhar
Janani Sekhar

Further, subject to a minimum lock-in period of one year (from the date of allotment of shares) or the prescribed minimum lock-in in the FDI regulations, whichever is higher, foreign investors holding the shares or debentures of an Indian company containing an optionality clause and exercising the option have been permitted to exit without any assured returns:

(i) In case of a listed company, at the market price prevailing at the recognized stock exchanges;

(ii) In case of equity shares of an unlisted company, at a price not exceeding that arrived on the basis of return on equity (i.e. profit after tax divided by net worth inclusive of free reserves and paid-up capital) as per latest audited balance sheet; and

(iii) In case of compulsorily convertible preference shares or debentures, at a price worked out using any internationally accepted pricing methodology at the time of exit, duly certified by a chartered accountant or a SEBI-registered merchant banker. The objective is to ensure that a foreign investor is not guaranteed any assured exit price at the time of making investments or agreements and exits at the price prevailing at the time of exit, subject to lock-in requirements.

All existing contracts are also required to comply with the above conditions to qualify as FDI compliant.

Thus, while SEBI and the RBI have removed the uncertainty surrounding enforceability of options and their pricing, it appears that there is a significant mismatch between the commercial objectives of foreign investors and the jurisprudence governing the function of the RBI.

Amit Kumar is a partner and Janani Sekhar is a senior associate at Amarchand & Mangaldas & Suresh A Shroff & Co. The views expressed in this article are those of the authors and do not reflect the position of the firm.

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