Finance Ministry to Allow Call and Put Options in Share Purchase and Investment Agreements

The existing grey area in the legal validity and enforceability of the call and put options as standard boilerplate clauses in various strategic investment agreements in its present form is likely to be done away with. The Ministry of Finance is in talks with the Market regulators SEBI and RBI to recast regulations to allow companies to use call and put options in various strategic deals like Mergers and Acquisitions, exit from a company through buy back of shares, etc. SEBI had earlier directed Cairn India and Vedanta to remove the call and put option clauses from their Share purchase Agreement in the much controversial Cairn Vedanta Deal which created quite a stir among the India Inc. Also in the matter of Vulcan Engineering Limited, SEBI by an interpretive letter made it clear that call and put options are violative of Sec 16 and Sec 18A of the Securities Contract Regulation Act, 1956 and hence unenforceable1. Department of Industrial Policy and Promotion (DIPP) also in its consolidated FDI policy released on September 30, 2011, said, equity instruments issued/transferred to non-residents having in-built options such as call or put or supported by options sold by third parties would lose their equity character and such instruments would have to comply with the extant ECB guidelines 2. After much hue and cry and later anticipating a lull in the inflow of foreign investments into the economy, such a clause was ultimately scrapped by the Finance Ministry. A put option is the right (but not obligation) of a holder of shares in a company to sell those shares to another person at a pre-determined price (being the strike price). When the option is exercised by such shareholder, the other person (being the buyer) will be obligated to purchase the shares at the strike price. The converse of a put option is a call option, which grants the right (but not the obligation) to a person to acquire shares in a company from an existing shareholder at a strike price. When an option is exercised by the holder thereof, the shareholder (being the seller) will be obligated to sell the shares to the option holder at the strike price. The logical conclusion of the exercise of either a put option or a call option would be the transfer of the relevant shares from the seller to the buyer at the strike price. Put and call options are ubiquitous in modern investment agreements, such as those involving joint ventures as well as private equity and venture capital investments. But the enforceability of such options has been questioned on the basis of the provisions of the Securities Contract Regulation Act, 1956 which governs the procedure for transfer of marketable securities that are freely transferable. The SCRA covers the public companies-both listed and unlisted as their securities are Marketable being freely transferrable.3 It however does not cover the Private companies as there are restrictions in the transferability of its shares and hence are not Marketable.4 According to Sec 16 of the SCRA, transfer of securities shall be on a spot delivery basis or contract for cash or hand delivery basis. Any other modes of transfer of securities shall be void. Further Sec 18A provides that any contract in derivatives shall be legal and valid only if such contracts are traded on the
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http://www.sebi.gov.in/informalguide/Vulcan/sebilettervulcan.pdf http://dipp.gov.in/English/Policies/FDI_Circular_02_2011.pdf 3 Mysore Fruit Products Ltd. and Ors .Vs. The Custodian and Ors. [2005(1)ALLMR278], A K Menon v Fairgrowth Financial Services Ltd. (1995) 2 Comp LJ 59 4 Norman J. Hamilton and Anr. Vs. Umedbhai S. Patel and Ors [1979]49CompCas1(Bom)

platform of a stock exchange and settled through a clearing house. In Rajshree Sugars and Chemicals Ltd. vs. Axis Bank Ltd.5 it was held that Options (both put and call) are treated as a form of derivatives, as they derive their value from the underlying shares. Hence Sec 18A makes such options in an agreement invalid and unenforceable since such options are not traded on exchanges. In Dahiben Umedbhai Patel v. Norman James Hamilton6, the Bombay High Court had held such contracts as Forward Contracts and hence not being Spot Delivery Contracts are unenforceable. Similar views were also taken in Niskalp Investments and Trading Co. Ltd. v. Hinduja TMT Ltd7 and also in the Bank of India Finance Case8. However, with the recent decision of the Bombay High Court in the case of MCX Stock Exchange vs. SEBI9, there has been a fundamental change in the legal status of call and put options as standard clauses in a share purchase agreement. The Bombay High Court in this case has rejected the contention that such an arrangement of buy-back of shares pursuant to call and put option clauses in a share purchase agreement are in the nature of forward contracts. The Bombay High Court made a clear distinction between a Forward Contract and an Option Contract. The High Court observed that in case of options, the same constitute the privilege of the option holder, the exercise of which depends upon their unilateral volition. If the option holder declines to exercise it, the counterparty cannot compel performance of the contract. It was also observed by the Honble High Court that an option contract is materialized on the happening of a trigger event as specified in the contract and when the shares are actually transferred on the happening of that trigger event it happens on a Spot Delivery basis and hence are not violative of Sec 16 of the SCRA. On the question whether such agreements are in the nature of Derivative transactions and hence illegal as per Sec 18A of the SCRA, it was interpreted that on a bare perusal of section 18A, it appears that what is prohibited there under is a contract in derivative which is in itself a subject matter of trade, and not a mere option agreement which cannot be assigned freely and which is tailor-made to cater to specific requirements of parties to negotiated agreements. It should now be possible for parties to privately negotiated deals who hold options to sell or purchase shares, to argue that a mere option, which in itself is not freely transferable, should not be treated as a contract in derivative. Pursuant to the decision of the Bombay High Court in the MCX case and also a voice of concern being raised by the Corporate Houses in favour of allowing such Option Clauses in investment agreements to structure the exit rights of investors, the Finance Ministrys effort to recognize the validity of options is a welcome move.

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(2008) 8 MLJ 261 [1985] 57 CompCas 700 (Bom.) 7 [2008] 143 CompCas 204 (Bom) 8 (1997) 10 SCC 488:[1997] 89 Comp. Cas. 74 (SC) 9 W.P. No. 213 of 2011