In what can be perceived as a paradigm shift in a long held position, the Securities and Exchange Board of India (SEBI) on 3 October issued a notification allowing investors to include pre-emptive rights and put/call options in shareholders’ agreements and articles of association of companies. Prior to this, much confusion existed with respect to the validity of options and the issue has been the subject matter of a number of cases (Niskalp Investments, Vulcan Engineers, MCX Stock Exchange, USL Diageo, Cairn Vedanta, etc.).
SEBI was earlier of the view that a put/call option to foreign investors would amount to a one-to-one derivative contract, and such contracts were largely not enforceable pursuant to the Securities Contracts (Regulation) Act, 1956.
Pursuant to the above notification, which supersedes the earlier notification dated 1 March 2000, in addition to spot delivery contracts and sale and purchase contracts of securities or derivatives through a recognized stock exchange (which were already permitted earlier), contracts for pre-emption – including right of first refusal and tag-along/drag-along rights contained in shareholders’ agreements or articles of association of companies – will now be valid without requiring prior permission of SEBI.
The notification validates the contentious put/call options in shareholders’ agreements or articles of association of companies, provided: (i) the title and ownership of the underlying securities that are the subject matter of the option are held continuously by the selling party for a minimum period of one year from the date of entering into the contract; (ii) the price or consideration payable for the sale or purchase of the underlying securities pursuant to exercise of the option is in compliance with the then applicable laws; and (iii) the contract is settled by way of actual delivery of the underlying securities. Additionally, the notification requires such a put/call option contract to be in accordance with Foreign Exchange Management Act, 1999, and the rules and regulations made under it.
The notification will apply prospectively, so previous contracts with pre-emption rights or put/call options will not be grandfathered. In the event of doubt in relation to the validity of an option, parties may opt to obtain the benefit of the present notification by re-executing the existing contracts.
Exit mechanisms for investors typically include an initial public offering (IPO), buyback of shares by the investee company, put/call options and tag along/drag along rights. Although, floating shares of the investee company in an IPO is usually the most preferred exit route, various market-driven factors often make listing unfeasible as an exit mechanism. In such cases, investors look at other exit routes, such as a put option.
Although SEBI has cleared the way for options (as above) in an investment agreement, foreign investors may continue to remain somewhat concerned in light of the position maintained by the Reserve Bank of India (RBI). The RBI, in the recent past, has discouraged options, especially put options with fixed returns, as it views such options as external commercial borrowing. It has not yet disclosed its views subsequent to the notification.
Understandably, the RBI is concerned that fixed returns options, which are not risk bearing, are in substance indebtedness on the country’s balance sheet rather than equity derivatives, which carry equity risks.
Pursuant to passage of the Companies Act, 2013, the parliament has cleared the doubts in relation to restrictions on transferability of shares of public companies. Consequently, put/call options, which may have been considered as restrictions on transferability of shares of public companies, are now valid and enforceable under the company law.
Overall, it is a step in the right direction, as it seeks to rectify a previously ambivalent and restrictive legal regime. However, a real change in the regulatory environment, as far as foreign private equity investors, institutional investors, joint venture partners, etc., are concerned, will only set in once the RBI clarifies its position with respect to an option with fixed returns and an option that is tagged to the fair market value of the shares at the time of exit.
Such a clarification would provide much needed comfort to foreign investors and end the regulatory uncertainty over options which has marred many a foreign investment opportunity. But will this happen anytime soon?
Pankaj Agarwal is a partner, Hrishikesh Waghela is a senior associate and Amit Kumar is an associate at Amarchand & Mangaldas & Suresh A Shroff & Co, Ahmedabad. The views expressed in this article are those of the authors and do not reflect the position of the firm.
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