Wednesday, October 9, 2013

Analysis of SEBI Notification on Pre-emption Rights and Options – Part 1

[Last week, we had discussed SEBI’s recent notification granting conditional validity to pre-emption rights and options in securities of Indian companies.

In the following two-part post, Ms. Sikha Bansal of Vinod Kothari & Company provides a detailed background to SEBI’s recent reforms and analyses their impact. She can be reached at]

In our elaborative article titled, Exit Options in Equity Investments in India: Recent Issues on Legality[1] (the “previous article”), it has been discussed whether ‘options’, as an exit mechanism for private equity investors, are enforceable under Indian laws. The issue has been thoroughly discussed in the light of the statutory provisions contained in the Securities Contracts (Regulation) Act, 1956 (the “SCRA”) read with the relevant notifications issued and related judicial precedents. In this context, it is relevant to recall that in view of a notification issued in the year 2000, the Securities and Exchange Board of India (the “SEBI” or the “regulator”) held that contracts including right of first refusal, or those contracts involving pre-agreed buy-back of shares through call/put options to be invalid if they are not spot delivery contracts. However, the aforesaid mentioned notification has been rescinded recently, and SEBI has now expressly permitted previously prohibited contracts. This post analyses the impact of such changes.

1.         Position before the notification

As mentioned, SEBI, vide Notification No. SO 184(E) dated 1 March 2000[2] (the “previous notification”), prohibited any person to

“enter into any contract for sale or purchase of securities other than such spot delivery contract or contract for cash or hand delivery or special delivery or contract in derivatives as is permissible under the said Act or the Securities and Exchange Board of India Act, 1992 (15 of 1992) and the rules and regulations made under such Acts and rules, regulations and bye-laws of a recognized stock exchange”,

except with the permission of SEBI.

Further, in November, 2011, SEBI, in two cases involving shares of listed companies very clearly viewed that put and call options are invalid and unenforceable, and will not be given effect to by the regulator. In the ruling related to the public takeover of Cairn India Limited[3] the put option and call option arrangements and the right of first refusal were held not to be conforming to the requirements of a spot delivery contract nor with that of a contract of derivatives as provided under Section 18A of the SCRA and, therefore, held illegal. Simultaneously, in an informal guidance[4] issued by SEBI to Vulcan Engineers Limited, it was explained that a pre-agreed buy-back of shares through put/call option will not be valid in view of the provisions of SCRA and the Notification No. SO 184(E).

2.         U-turn: The new notification

Recently, SEBI, vide its Notification dated October 3, 2013[5] (the “notification”), has rescinded the previous notification, and has specified an extended list of contracts that would be valid and would not require SEBI’s permission.  The following contracts have been permitted to be entered into, without obtaining the permission of SEBI:

1. Spot delivery contracts. Therefore, the position is status quo vis-à-vis the previous notification.

2. Contracts for sale or purchase of securities or contracts in derivatives permissible under SCRA or the Securities and Exchange Board of India Act, 1992 (the “SEBI Act”), as was also permitted under the previous notification.

3.         Contracts for pre-emption including right of first refusal, or tag-along or dragalong rights contained in shareholders agreements or articles of association of companies or other body corporate.

4. Contracts in shareholders agreements or articles of association of companies or other body corporate, for purchase or sale of securities pursuant to exercise of an option contained therein to buy or sell the securities, where-

i. the title and ownership of the underlying securities is held continuously by the selling party to such contract for a minimum period of one year from the date of entering into the contract;

ii. the price or consideration payable for the sale or purchase of the underlying securities pursuant to exercise of any option contained therein, is in compliance with all the laws for the time being in force as applicable; and

iii.                the contract is settled by way of actual delivery of the underlying securities.
General conditions imposed on entering into such contracts are:

1. The contracts shall abide by the Foreign Exchange Management Act, 1999 and rules or regulations made thereunder.

2.      The notification is not retrospective; it does not affect or validate any contract which has been entered into prior to the date of this notification.

Further, the contracts of sale or purchase of the following securities shall be in consonance with rules/regulations/bye-laws or any directions issued by SEBI under the SCRA and the SEBI Act; with the rules/guidelines/directions issued by the Reserve Bank of India (the “RBI”) under the Reserve Bank of India Act, 1934 or the Banking Regulation Act, 1949 or the Foreign Exchange Management Act; and with the notifications issued by the RBI under SCRA:
- government securities,
- gold related securities,
- money market securities, 
- contracts in currency derivatives,
- interest rate derivatives and
- ready forward contracts in debt securities.

Out of the above mentioned securities, contracts in currency derivatives and interest rate derivatives have been newly added.

Some of the contracts, which have been conferred validity under the notification, are discussed in detail herein below.

3.         Contracts for pre-emption including right of first refusal, or tag-along or drag-along rights

Contracts of pre-emption confer “first in the line” rights to the right holder. Under a “right to first refusal” clause, a party cannot sell its shares in any company held or acquired by it without first offering the shares to the other party. Here, the latter has the right to first refuse the offer. If the party in exercise of the rights conferred, refuses to purchase the shares so offered the former party shall be free to sell the shares to other persons. As also discussed in our previous article on the issue, the Bombay High Court in Messer Holdings Limited v. Shyam Madanmohan Ruia[6] held that private arrangement in relation to shares are not in violation of section 111A of the Companies Act, 1956.

In the international context, the validity of drag along rights has been upheld in Minnesota Invco of RSA #7, Inc. v. Midwest Wireless Holdings LLC[7].

Detailed discussion regarding the legality of such clauses in the shareholders’ agreement has been made in the article titled “Legality of a Shareholders’ Agreement-Can shareholders agree outside the Articles?”[8]

(The next part will consider the impact of the notification on options in securities and its interplay with other legislation, including foreign exchange laws and the Companies Act)

- Sikha Bansal

[2] Reproduced in Adjudication Order No. BM/AO - 137/2013, see here: ; p.9
[3] See Letter of Offer to the Shareholders of Cairn India Limited. Copy of the Letter is available at
[4] See the SEBI Letter dated May 23, 2011 addressed to Vulcan Engineers Ltd. Copy of the Letter is
[6] [(2010) 98 CLA 325]
[7] , [2006 WL 1596675]

1 comment:

sunil sheth said...

Even the recent SEBI notification does not clearly mention: whether any ROFR already entered into between the co-promoters years ago and exist in the shareholder agreement would be VALID as per the recent SEBI notification ? OR only those ROFRs that are entered only after the above SEBI notification would be valid??