SEBI permits options and preemptive rights arrangements
The Securities and Exchange Board of India ("SEBI") has by its recent notification1 ("Notification"), agreed to include clauses relating to preemptive rights, right of first offer, tag-along right, drag-along right and call and put options, when contained in shareholders' agreements, as valid contracts, for the purpose of the Securities Contract Regulation Act, 1956 ("SCRA").
There has always been confusion on the kinds and the type of contracts that can be entered into with respect to 'marketable securities' under the SCRA.
SEBI issued a notification in 20002, pursuant to which it prohibited all contracts, except spot delivery contracts or contracts for cash or delivery or contract in derivatives, in territories to which the SCRA applied.
Section 16 of the SCRA empowers the Central Government to declare by notification that no person may enter into any contract for the sale or purchase of any security specified in that notification, if it is of the opinion that it is 'necessary to prevent undesirable speculation in specified securities'. Section 28 (2) empowers the Central Government, by notification, to specify any class of contracts as contract to which the SCRA shall not apply, if it is satisfied that it is necessary in the interests of trade and commerce or the economic development of the country. Section 29A of the SCRA further empowers the Central Government, by a notification, to delegate the powers to SEBI or Reserve Bank of India ("RBI").
By a notification in 19923, the Central Government delegated the power under Section 16 of the SCRA to SEBI. Amending this notification, the Central Government issued another notification in 20004 distributing the power among SEBI and RBI such that in relation to any contracts in Government securities, money market securities, gold related securities and in securities derived from these securities and in relation to ready forward contracts in bonds, debentures, debenture stock, securitized debt and other debt securities, the powers under Section 16 would be exercisable by RBI.
In this background, the validity of the preemptive rights, the drag along and tag along rights, call and put options was always questionable.
This issue has been the subject matter of a number of cases.
In 2005, the Bombay High Court5, while dealing with buy back clause in a share purchase agreement, held that such a clause would not be valid under the SCRA since it is not a spot delivery contract.
In 2011, SEBI issued an informal guidance6 stating that an agreed purchase of shares of a listed company through call or put option of a listed company is not valid, since it does not constitute a spot delivery contract. In addition, the contract is not a valid derivative under SCRA since it is not a contract traded on stock exchanges and settled on the clearing house of a stock exchange.
In 2012, the Bombay High Court, while dealing with options for the purchase or sale of securities between the parties, in the case of MCX Stock Exchange Limited vs. SEBI7, held that options are merely the privilege of the option holder, and a concluded contract for the sale and purchase would come into existence only on the exercising of the option by the option holder. The court also distinguished between a futures contract, which was a contract for the purchase or sale of securities in future at a determined price, and options, which were mere privileges in the hands of the option holder8. However, the appeal filed by SEBI by way of a Special Leave Petition was disposed off by the Supreme Court on the basis of the consent terms filed by the parties.
By way of the Notification, SEBI has enhanced the scope of contracts that are valid under the SCRA. By notification S.O. 184 of 2000, SEBI had limited the scope of permissible contracts to spot contracts and derivative contracts. However, by the Notification, the following have now been included within the scope of permissible contracts under SCRA:
The contract for the purchase or sale of securities pursuant to the exercise of an option under clause (d) above is subject to certain conditions:
In addition, the Notification clarifies the following:
The issue of the validity of call and put options has been debated frequently. SEBI has earlier held options to be invalid in Vulcan Engineering, and recently, has even asked parties to remove put options from their agreements, as in the recent case of Vedanta Resources Plc's acquisition of Cairn India Limited. Hence the Notification is a welcome move and will bring great relief - to the domestic investors, at least.
Having said that, the call and put options are subject to extant exchange control regulations. RBI has been holding such options invalid on 2 counts. First, that they were not valid contracts under SCRA, and second, that they were in the nature of debt. By way of the Notification, the first of the two issues have been addressed. To that extent, since put options is more pertinent to the second objection- it remains to be seen whether call option would now be permitted. It seems that SEBI may have consulted with the RBI before coming out with the Notification, and it is expected that RBI may soon permit options and preemptive rights from an exchange control perspective, thereby clarifying the issue in relation to these contracts.
– Abhinav Harlalka, Deepak Jodhani, Simone Reis & Nishchal Joshipura
You can direct your queries or comments to the authors
2 Notification S.O. 184 (E) dated March 1, 2000
3 Notification S.O. 573 (E) dated July 30, 1992
4 Notification S.O. 183 (E) dated March 1, 2000
5 Niskalp Investments and Trading Co. Ltd. vs. Hinduja TMT Ltd. [ 143 Comp Cas 204 (Bom)]
7 2012 (114) BomLR 1002
9 The foreign direct investment policy only permits equity instruments or instruments compulsorily convertible into equity.