While the rise of India as an investment destination has been one of the hallmarks of the geopolitical changes that have occurred over the past decade, the narrative has always been tarnished by grievances from the international investor community about the stringent and often opaque regulatory regime in India.
Over the past few months, the government of India has introduced a host of legislative and regulatory initiatives that have brought much-needed cheer to market sentiments by liberalising investments in key sectors, enacting a new Companies Act, and providing additional exit avenues for domestic and international investors.
One of the most significant recent changes was brought about by a notification of the Securities and Exchange Board of India (SEBI), India’s apex regulator of the securities market; vide its notification 3 October 2013 (the 3 October Notification), SEBI has given a de jure legal validity to option contracts and contracts for pre-emption entered into by listed and unlisted public companies.
INVALIDATION OF OPTIONS
Investors have a number of instruments and rights at their disposal when structuring and securing their private equity and venture capital investments across the world, and the right to buy and sell securities pursuant to put and call options has often been their tool of choice in structuring modern investment agreements.
While the enforceability of put and call options has been tested and determined beyond reasonable doubt in various jurisdictions, these contracts have often been held unenforceable when entered into by listed and unlisted public companies in India. As a result, investors have found themselves in an unfortunate position whereby they have imported provisions for put and call options from other jurisdictions and placed them in their investment agreements in India without due consideration that these agreements themselves would be challenged and invalidated based on the notifications of SEBI and the provisions of the Securities Contract (Regulation) Act, 1956 (the SCRA).
HISTORICAL LEGISLATIVE OVERVIEW
The legal jurisprudence with respect to option contracts in India began with the Division Bench of the Bombay High Court, which in Jethalal C Thakkar v R N Kapur upheld the validity of an option contract in the context of the erstwhile Bombay Securities Contracts Control Act, 1925, and held that an option contract was a ready delivery contract (and not a forward contract) due to its contingent nature, and that an option contract does not crystalise until the pre-determined event has occurred.
The Bombay Securities Contracts Control Act, 1925 was replaced by the SCRA in 1956, and the SCRA became the primary regulation governing the validity of contracts for the sale and purchase of securities in India, including option contracts and contracts for pre-emption.
Further, the SCRA expressly empowers the central government to invalidate contracts as it deems necessary to prevent undesirable speculation in specified securities through the issue of periodic notifications. With such a wide mandate to govern commercial contracts pertaining to the sale and purchase of securities, the SCRA and subsequent notifications by the government have led to a turbulent situation where liberalisation and conservatism have often existed side by side.
While the government, vide its notification of 27 June 1961, specifically excluded contracts for pre-emption from the purview of the SCRA, it also declared all contracts for the sale and purchase of securities other than spot delivery contracts or contracts settled through the stock exchange void, vide its notification of 27 June 1969 (the 1969 Notification).
The 1969 Notification was repealed on 1 March 2000, and SEBI released a new notification on the same date that prohibited contracts other than spot delivery contracts or those entered into through the stock exchange mechanism, which reaffirmed the restrictions placed in the 1969 Notification.
As a result, option contracts entered into by listed and unlisted public companies in India were held to be unenforceable, while contracts for pre-emption were excluded from the purview of the SCRA until 2011.
IMPACT OF THE SCRA
The impact of the SCRA on contracts for pre-emption and option contracts can be seen in the following prominent examples:
Vedanta Resources PLC wanted to acquire the shares held by Cairn Energy PLC in Cairn India Limited, and included provisions for pre-emption rights and put and call options in the definitive agreements.
When Vedanta Resources PLC issued a letter of offer to acquire the shares from Cairn Energy PLC, it was disclosed that SEBI had taken the view that the right of first refusal and the put and call options stated in the definitive agreements were in violation of Notification No. SO 184(E) of 1 March 2000, since these contracts did not conform to the requirements of either a spot delivery contract or a contract of derivatives under section 18A of the SCRA.
Such view by SEBI not only reinforced its stand on the unenforceability of option contracts; it also showcased the change in SEBI’s view regarding the enforceability of contracts for pre-emption. This latter was surprising as SEBI had, in its notification of 27 June 1961, expressly excluded contracts for pre-emption from the purview of the SCRA, and said notification was never repealed by SEBI.
Vulcan Engineers Limited
Terruzzi Fercalx SpA (Terruzzi), a foreign company incorporated in Italy, held shares in the share capital of Vulcan Engineers Limited (VEL), a company listed in India. Under a proposed preferential allotment of 13.79 per cent of VEL’s shares to SIMEST SpA (SIMEST), SIMEST would have the right to exercise its option to sell all the VEL shares it owned to Terruzzi over an agreed period of time, and Terruzzi would be obliged to purchase the shares offered by SIMEST after complying with all applicable laws in India.
Based on the above, SEBI opined that, as the option is exercisable on a future date, the transaction would not qualify as a spot delivery contract as defined under section 2(i) of the SCRA, and that the option would not qualify as a legal and valid derivative contract in terms of section 18A of the SCRA as it was exclusively entered into between two parties and is not a contract traded on stock exchanges and settled on the clearing house of a recognised stock exchange.
This informal guidance affirms the stance taken by SEBI on the validity of option contracts.
MCX Stock Exchange
In SEBI v MCX Stock Exchange, in which an order of SEBI was challenged before the courts, the Bombay High Court dealt with the issue of the validity and enforceability of buyback arrangements under law, and more specifically the SCRA. The Court’s ruling took into account (1) whether buyback arrangements constitute a forward contract, which would be construed to be illegal; (2) whether the SCRA applies to unlisted public companies; and (3) whether the options violate section 18A of the SCRA as they are not traded and settled through a stock exchange.
On the first question, the Court opined that a buyback would come into being only at a future point in time, in the eventuality of the party that is granted an option exercising it. Once such option is exercised, the contract would be completed only by the means of spot delivery or by another mode that is considered lawful. On the second issue, it concurred that the SCRA will apply to unlisted public companies. It refused to give its rationale on the third issue, citing procedural grounds.
Recognition of pre-emption rights and options in securities in India under the 3 October Notification
The 3 October Notification rescinds the SEBI notification dated 1 March 2000 and declares that, save with the permission of SEBI, no person in India can enter into any contract for sale or purchase of securities other than a contract falling under any one (or more) of the following categories:
- spot delivery contracts;
- contracts for the sale or purchase of securities or contracts in derivatives as permissible under the SCRA or the SEBI Act, the rules and regulations made under these acts, and the rules, regulations and by-laws of a recognised stock exchange;
- contracts for pre-emption, including the right of first refusal, and tag-along or drag-along rights contained in shareholders’ agreements or the articles of association of companies or other body corporate; and
- contracts contained in shareholders’ agreements, or the articles of association of companies or other body corporate, for the purchase or sale of securities.
BENEFITS AND LIMITATIONS
Enforceability of options
The 3 October Notification accords recognition to a contract for the purchase or sale of securities pursuant to the exercise of an option to buy or sell securities as long as:
- the title and ownership of the underlying securities is held by the selling party for a period of one year;
- the price or consideration payable for the underlying securities must be compliance with the applicable laws; and
- the contract is settled by way of actual delivery of the underlying securities.
The pre-conditions that have been imposed by SEBI on the enforceability of options showcases the legislative intent whereby a bona fide transaction that conforms to a minimum lock-in period and the relevant pricing guidelines, and that is not a contract for differences, can be validly entered into by parties in India.
The recognition of options as a valid contract is a significant change from SEBI’s earlier stance, and will enable investors to use options as a tool while structuring their investments into India.
While SEBI, vide its notification dated 27 June 1961, expressly excluded contracts for pre-emption from the purview of the SCRA, the view taken by SEBI in the Cairn–Vedanta deal was a direct departure from the view it had taken in its 1961 notification. The 3 October Notification reaffirms SEBI’s earlier view, although this time it gives a de jure recognition to contracts for pre-emption, including the right of first refusal, and tag-along or drag-along rights contained in shareholders’ agreements or the articles of association of companies or other body corporate.
The 3 October Notification expressly states that the provisions of the extant notification shall not be applicable to any contract that has been entered into prior to the date of the said notification. The prospective applicability of the new regime may render contracts that were executed prior to 3 October 2013, and those that have pre-emption rights and put or call options, unenforceable. It is recommended that parties revisit their contracts for the sale and purchase of securities containing the provisions for options and pre-emption rights, and re-execute these contracts as per the current date.
SEBI is to be applauded for taking a bold step with the 3 October Notification, and for expressly stating that a party is free to enter into contracts with options and pre-emption rights.
The SCRA Notification will also bring a much-needed boost to market sentiments and act as a shot in the arm for companies that are seeking to raise fresh capital. We can only hope that the Companies Act, 2013 does not conflict with or in any manner dilute the freedom that is accorded under the SCRA Notification once all the provisions of the Companies Act are notified, and the Reserve Bank of India abandons its stance that the sale or purchase of securities by foreign investors pursuant to options is construed as debt rather than an equity investment.
 Notification S.O. LAD-NRO/GN/2013-14/26/6667.
 (1955) 57 Bom. LR 1051.
 Notification S.O. 1490.
 Notification S.O. 2561.
 Notification S.O. 184(E).
 Notification S.O. 1490.
 SEBI Informal Guidance No. CFD/DCR/16403/11, 23 May 2011.
 MCX Stock Exchange Limited v Securities & Exchange Board of India Limited (W.P. No. 213 of 2011 – Bombay HC).
 Securities and Exchange Board of India Act, 1992 (15 of 1992).