
Introduction
In this article, we seek to specifically deal with enforceability of put option clauses in shareholders agreement and specific issues concerning the same, in addition to the issues and recommendations concerning enforceability of any special rights agreed under a Shareholders Agreement generally, which will apply as well to the put option clauses. For knowing about these principles generally applying to shareholders agreements and special rights agreed thereunder, readers are requested to go through our article titled as , ‘Shareholders Agreement, Rights of Shareholders under the Agreement and Enforceability Thereof,’ at https://rdlawchambers.com/research-articles/
A put option is a contract that provides the holder with the right, but not the obligation, to sell a specified quantity of equity shares within a stipulated time frame at a price determined in advance under the agreement. Irrespective of the market price of the equity at the time of exercising the option, the holder of the put option retains the right to sell the security at the predetermined price.
Such option contracts are available for purchase or sale on the stock exchange in connection with the securities of certain high-market capital companies. In this article, we will discuss the put option in shareholder agreements, particularly when an investor seeks to invest in an unlisted company and includes a put option as one of the exit rights(along side any other exit rights such as obligations for company to pursue an IPO, strategic sale of securities to a third party, drag-along/ tag-along rights etc.) to ensure a guaranteed exit at a pre-agreed valuation.
History of the Legality of the Put Option Clause
Legality of a put option has never been a subject matter of contest on grounds of violation of any provisions of Indian Contract Act(ICA). Put option clauses however, have been the subject matter of controversy due to issues surrounding their legality in light of different notifications from SEBI (the Securities and Exchange Board of India) and provisions of the SCRA (Securities Contracts Regulation Act).
It was in 1969 that a notification was issued under the SCRA, which provided that contracts related to buying or selling of securities, except spot delivery contracts or contracts settled through the stock exchange, are illegal and void.
This notification was repealed in 2000, but SEBI issued another notification on 1st March 2000, which stated that no person shall, save with the permission of the board, enter into any contract for sale or purchase of securities other than a spot delivery contract, a contract for cash or hand delivery, or a contract in derivatives as permissible under the SCRA or the SEBI Act.
In 2011, SEBI also issued an informal guidance considering options to be in the nature of forward contracts or derivatives under the SCRA, providing that call or put options did not fall under the category of spot delivery contracts and were therefore not valid.
SEBI issued yet another notification on 3rd October 2013, superseding the 1st March 2000 notification, which provided that contracts in a shareholder’s agreement or articles of association of a company for purchase or sale of securities pursuant to the exercise of an option contained therein could be entered into without the board’s permission if:
- The title and ownership of the underlying securities were held by the selling parties to such contracts for a minimum period of one year from the date of entering into the contract.
- The price or consideration payable for the sale or purchase of underlying securities pursuant to the exercise of any option was in compliance with all applicable laws.
- The contract was settled by way of actual delivery of the underlying securities.
With the advent of the 2013 SEBI notification, there is no prohibition against entering into a contract of option that fulfils the conditions stipulated in the 2013 notification as highlighted above, and such contracts are enforceable. Furthermore, in a recent decision of the Bombay High Court in the case of Edelweiss Financial Services Ltd. vs. Percept FinServ Private Ltd., it was held that a put option was not a forward contract, as the contract essentially came into existence upon the exercise of the put option and was ultimately settled on a spot delivery basis.
The Bombay High Court further considered an argument pertaining to such contracts being in the nature of derivatives within the meaning of Section 18-A of the SCRA, and a consequent argument about put options being invalid unless traded on a recognized exchange, settled in the clearing house of a recognized stock exchange, or between such parties and on such terms as the Central Government may specify in accordance with the rules and bylaws of such stock exchange in light of provisions of s.18-A of SCRA.
Interpreting Section 18-A, the Bombay High Court held that Section 18-A did not impose any restrictions on entering into such contracts, but dealt solely with the trading or sale/purchase of such contracts. More importantly, Bombay High Court held that there never(not even before SEBI notification from 2013) was a prohibition against entering into a contract for grant of put option.
Analysis and Recommendations
While there is no Supreme Court decision on the validity of put option contracts entered into during the period of 2000-2013, author tends to agree with the reasoning of the Bombay High Court in the above-referred case. However, the argument that option contracts entered into during the period between 1st March 2000 and 2013 were invalid could still be expected, unless the matter falls within the jurisdiction of the Bombay High Court, where the decision in the case of Edelweiss Financial Services Ltd. vs. Percept FinServ Private Ltd. would be binding in the absence of a Supreme Court decision.
In any case, there is no dispute regarding the enforceability of put option contracts entered into after the 2013 SEBI notification. There however may be a requirement for compliance to RBI guidelines, FEMA regulations and FDI policy of India, in case such option is granted to a non-resident.
Put options granted to Non-Residents
When entering into any put option contract today, we recommend that, in cases where the contract is granted to a non-resident, conformity with RBI circulars should be checked. Previously, the RBI treated put options granted to non-residents as redeemable instruments giving a guarantee of assured returns, which were not permitted under India’s foreign direct investment policy. However, RBI has now permitted put options to be issued to non-residents, even by unlisted companies, via circulars issued in January and July 2014, provided that such option contracts did not guarantee an assured return or short return at the time of making the investment by such non-residents. Therefore, we recommend carefully perusing these circulars, applicability thereof depending on who the option was being granted and drafting option contracts accordingly to comply with the above circulars.
Put Option right Against the Company
While options providing that they could be exercised against the shareholder/promoter as well as against the company are not common, in practice, we have come across option contracts that also provide for the buyback of shares by the company itself, as opposed to put options between the holders of equity. When the option is sought to be exercised against the company issuing the underlying equity, enforceability of such an option will be subject to further conditions stipulated in the Companies Act pertaining to compliance requirements for buyback of securities by a company, and FEMA regulations (in case the company is buying back securities from foreign shareholders).
*The content of this article is intended to provide general information. No reader or user should act or refrain from acting on the basis of the information written above without first seeking legal advice from a qualified law practitioner.