Call and put options (options) in relation to equity instruments of an Indian company’s shares are common in corporate transactions involving joint ventures, acquisitions, private equity, venture capital and strategic investments, etc.
After the controversy around the validity of options in relation to shares a few years back, the Reserve Bank of India (RBI) and the Securities and Exchange Board of India (SEBI) laid out specific rules in 2013-14 permitting such options subject to certain conditions. However, certain ambiguities continue to remain.
SEBI rules do not apply to private companies. RBI rules do not apply to a pure domestic deal (not involving any person resident outside India or NR). Accordingly, both RBI and SEBI rules apply if an option involves both NR and a public company (listed or unlisted).
For options involving shares of a public (listed or unlisted) company, SEBI rules (in addition to non-debt instruments or NDI rules) would apply, which provides (a) for a lock-in of one year, (b) that the price of shares on exercise should be compliant with applicable laws and (c) that the contract should involve an actual delivery of shares.
An attempt has been made in this article to highlight some ambiguities arising out of the RBI rules with particular reference to options relating to shares of a private company and options agreed to between residents and NRs.
The relevant provisions under the Foreign Exchange Management (NDI) Rules, 2019 are as follows:
Equity instruments mean equity shares, convertible debentures, preference shares and share warrants issued by an Indian company.
Equity instruments can contain an optionality clause subject to a minimum lock-in period of one year or as prescribed for the specific sector, whichever is higher, but without any option or right to exit at an assured price.
Transfer of equity instruments of an Indian company by or to a person resident outside India: A person resident outside India holding equity instruments of an Indian company or units in accordance with these rules or a person resident in India, may transfer such equity instruments or units so held by him in compliance with the conditions, if any, specified in the schedules of these rules and subject to the terms and conditions prescribed hereunder:
A person resident outside India holding equity instruments of an Indian company containing an optionality clause in accordance with these rules and exercising the option or right, may exit without any assured return, subject to the pricing guidelines prescribed in these rules and a minimum lock-in period of one year or minimum lock-in period as prescribed in these rules, whichever is higher.
The definition of equity instruments as well as Regulation 9(5) of the NDI rules suggest that options should be contained in equity instruments. In other words, it can be said that the option should form part of the issuance terms and conditions.
Therefore, it can be argued that the NDI rules do not contemplate options being agreed between shareholders. However, such an interpretation would be impractical and, therefore, not intended by RBI. Options agreed between shareholders are most common today.
Under NDI rules, equity instruments having an optionality clause (i) are subject to pricing guidelines (ii) should not have any assured price or assured returns and (iii) are subject to a minimum lock-in period of one year or as prescribed for the specific sector, whichever is higher (collectively, option restrictions).
It is generally understood that one of the primary reasons RBI introduced option restrictions was the central bank believed that Indian residents were receiving equity investments and providing put options to NRs with a minimum guaranteed price or returns.
RBI believed that such transactions were structured as equity, but were akin to a debt transaction. Accordingly, option restrictions were introduced in 2013 (this paragraph is hereinafter referred to as “Background for Introduction of Option Restrictions”).
The NDI rules do not expressly or specifically provide for following situations: (a) option is agreed between two NRs or (b) where an option is held by a resident exercisable on an NR or (c) option agreed between a foreign-owned and/or controlled Indian company (FOCC) and a resident or NR.
Options between two NRs:
Regulation 9(5) of the NDI rules (see above) provides that an NR holding shares containing an option in accordance with the NDI rules will be bound by option restrictions.
Further, the definition of equity instruments (see above) itself includes option restrictions. Accordingly, it can be argued that by virtue of the options restrictions being provided in the definition of equity instruments, it is implied that option restrictions would apply in all situations.
As a rule, a capital account transaction, if not specifically permitted, would need RBI approval. Options in relation to shares are capital account transactions and, accordingly, unless specifically provided, would require RBI approval.
In the present case, while NDI rules provide for a situation of NR holding options, the intent does not seem to be to cover options between two NRs.
Transfer of shares between two NRs does not involve monies moving in and out of India. Accordingly, other than sectoral restrictions, generally, transfers between NRs are free from most other restrictions.
Pricing guidelines do not apply in case of transfer of shares by NR to NR. Accordingly, the applicability of pricing guidelines as contemplated in option restrictions does not appear to be consistent with the general rule that pricing guidelines do not apply to transfer of shares between two NRs.
It can be argued that, while the restrictions relating to pricing guidelines and assured returns do not apply to options between NRs, the lock-in restrictions would still apply to options exercisable between two NRs.
Having said that, it can also be argued that as the restrictions relating to pricing guidelines and assured returns do not apply to options between NRs, the lock-in restrictions should also not apply to options exercisable between two NRs.
In view of the Background for Introduction of Option Restrictions and the points discussed above, it does not seem to be the intent of RBI to apply the option restrictions to options exercisable between two NRs.
The author believes that the market practice is, and is rightly so, not to apply the option restrictions in options between two NRs.
Options held by a resident exercisable on NRs:
As explained above, the NDI rules do not expressly provide for a situation where a resident Indian holds shares containing options exercisable on NRs. However, as the definition of equity instruments includes option restrictions, it can be argued that the option restrictions would apply to options held by residents and exercisable on NRs.
It can also be argued that as Regulation 9(5) specifically deals with option restrictions and only covers NRs holding options, the option restrictions should not apply to options held by residents.
It should be kept in mind that in such cases, monies move in and out of India. Accordingly, RBI may want to regulate such transactions.
In view of the Background for Introduction of Option Restrictions and the points discussed above, it does not seem to be the intention of RBI to make the option restrictions applicable to options held by residents exercisable on NRs.
While it is not free from doubt (due to the definition of equity instruments), the author believes that a practical view may be taken that the option restrictions should not apply to options held by residents exercisable on NRs.
Options involving FOCCs:
The NDI rules provide that an Indian company which has received indirect foreign investment is required to comply with the entry route, sectoral caps, pricing guidelines and other attendant conditions as applicable for foreign investment.
As can be seen, the language “other attendant conditions as applicable for foreign investment” seems too generic. In view of this general language, it can be argued that all investments in equity instruments by FOCCs would be subject to similar restrictions as applicable to NRs.
Further, due to the general language, there are several ambiguities around the applicability of certain provisions of NDI rules to FOCCs such as restrictions on deferred consideration, escrow, etc. The author has seen different lawyers and law firms taking divergent views due to the generic language.
One such ambiguity can also arise with regard to options. On the one hand, it can be argued that in view of the above generic language, Regulation 9(5) of the NDI rules (which is applicable to NRs) would apply to FOCCs and options restriction apply to FOCCs.
On the other hand, it can be argued that FOCC is a specific concept introduced by the NDI rules and, accordingly, unless it is specifically provided, the provisions of NDI rules (which are applicable to NRs) should not automatically apply to FOCCs.
The author believes that for the purposes of options, FOCCs should be treated as an Indian resident and the option restrictions should not apply to FOCCs.
The importance of call and put options in corporate transactions involving joint ventures, acquisitions, private equity, venture capital and strategic investments, etc. cannot be stressed enough.
There is a lack of clarity under prevailing laws on the issues discussed in this article. It is of paramount importance that the relevant legal provisions should be very clear and not suffer from any ambiguities to ensure a safe investment environment. No investor would like to be on the wrong side of law (much less foreign exchange laws) merely because there is an ambiguity.
It is also not practical for everyone to approach RBI for such basic issues. It would be helpful if RBI can take note of the ambiguities and clarify the correct legal position.
Bhavik Narsana is a partner in the corporate team at Khaitan & Co. Views expressed are personal and do not necessarily represent the views of the firm.