Put and call options are not new to the world of mergers, acquisitions and private equity investments and neither is the controversy always surrounding them. Both have co-existed. It is rare not to find call and put options in investment agreements, shareholders’ agreements and joint-venture agreements. These options are helpful in achieving certain objectives such as giving a right to an investor to subscribe and acquire additional shares or to sell shares at a pre-determined price and earn a pre-determined rate of return. However, the enforceability of put and call options has always been a matter of debate with conflicting views on this subject.
Until 1995, all ‘options in securities’ were considered illegal and were therefore prohibited by Securities Contracts (Regulation) Act, 1956 (SCRA). Further, the Indian government issued a notification in June 1969 wherein it was mentioned that all contracts for the sale and purchase of securities other than ‘spot delivery contracts’ or contracts settled through stock exchange are void. However, in 1995, Section 20 of SCRA, which said all options in securities shall be illegal and void, was omitted. Later in 2000, the 1969 notification was also repealed. This gave the hope that the provisions of Section 20 and the 1969 notification, which created roadblocks in the enforcement of options since repealed, will give way to these options to become valid. Unfortunately, that did not happen.
Also in 2000, SEBI issued a notification which in effect provided what the 1969 notification had provided. According to the 2000 notification, no person can enter into any contract for sale or purchase of securities other than spot delivery contract or contract for cash or hand delivery or special delivery of permissible contracts in derivatives. Since then there have been issues in the enforceability of put and call options with SEBI taking a view that such options do not qualify as spot delivery contracts under section 18 of SCRA and also not qualify as legal and valid derivative contracts in terms of Section 18A of SCRA as they are entered between private parties and are not contracts traded on stock exchanges and settled on the clearing house of the recognised stock exchange.
This view of SEBI has been an impediment for genuine acquisition transactions providing for put and call options in the agreements. Also, SEBI has in the past asked contracting parties to delete such options from their agreements, including in the Cairn-Vedanta deal and more recently in the deal involving Diageo and UB Group’s United Spirits Ltd.
Since almost all private equity investments also have such options in the shareholders’ agreement, it is very critical for a PE investor to have certainty regarding the enforceability of such options. Such options facilitate different objectives for a PE investor—a call option will give the investor an option to increase its stake in the investee company while a put option can provide an exit from investment. PE investors make investments in all kinds of companies, including private firms and public limited companies (both unlisted and listed). While the provisions of SCRA apply to public limited companies (both listed and unlisted), they do not apply to private limited companies. Therefore, any put and call option provided to a PE investor in a private limited company will have no concern and will be enforceable notwithstanding SEBI adverse views regarding such options. Thus, the concern on their enforceability is in case of public limited companies.
Last year, the issue of enforceability of these options came up before the Bombay High Court in the dispute between MCX Stock Exchange and SEBI. The Bombay High Court held that such option do not violate ‘spot delivery contract’ under section 18 of SCRA and hence is valid. However, the court did not pass any order on contracts in derivative under Section 18A of SCRA. Therefore, after this decision while complete clarity was ensured that such options are do not violate Section 18 of SCRA, the picture remained blurred with respect to Section 18A. Therefore, the case was only half solved.
SEBI appealed against the order of the Bombay High Court in the Supreme Court. In the apex court, the parties agreed to the consent terms with SEBI stating that the view of the Bombay High Court is not binding on it and thus diluting the decision of the Bombay High Court. In short, the issue of enforceability of these options was not laid to rest and the controversy continued and SEBI kept on believing that such options are invalid.
However, now we have experienced a major development with the law ministry passing a proposal to hold that call and put options are valid and they will be enforceable. This will now go to the finance ministry for approval and if approved an amendment will be brought to the SEBI laws to hold that such put and call options are valid and enforceable. This should bring clarity and cheer to PE investors as they will be able to enforce such options with complete certainty even in public companies—both in the listed and unlisted space.
However, even if these options are held valid from the SEBI regulations perspective, put and call options suffer ambiguity from the perspective of Companies Act, 1956. There are views that such options restrict the free transferability of shares in case of public companies and hence should be void. Again, it may be noted that even if such options are treated to be restricting the free transferability of shares, they will still be enforceable in the case of private companies as restriction on free transferability of shares can be provided in a private limited company. Therefore, if PE investors have put and call options in a private limited company, there isn’t any cause of worry on their enforcement even from the Companies Act’s perspective. However, it will be really good if there is complete clarity on such options in the case of public companies from the perspective of Companies Act. Interestingly, both the Companies Bill, 2012 and a judgment of the Bombay High Court provide that even in case of a public company, shareholders can contractually agree on restriction on transferability of shares. Therefore, even if a view is taken that put and call options are a restriction on free transferability of shares in a public company, the contracting shareholders (say the PE investor and the promoter) can contractually agree to provide for such options and if provided the contracting parties will be bound by them. So to that extent the risk of their enforceability can be mitigated.
Another issue is in the case of a foreign PE investor having a put option right. The RBI views an instrument carrying a put option right to be debt instrument and not an equity instrument and applies the same principle as applicable on borrowing from a foreign entity. Therefore, even if the proposal of providing legality to put and call option is approved by the finance ministry, for a foreign PE investor, there will still be issues under the foreign exchange regulations until RBI clarifies its position.
Surely the development is encouraging and if the law ministry’s proposal is approved and the law is amended it will make put and call option valid which can then be used by the PE investors to structure their investments and particularly their exit through put options at a time when other modes of exit such as the IPO are not giving good results.
(The author is a partner with J. Sagar Associates. Views are personal.)
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