Friday, October 11, 2013

Analysis of SEBI Notification on Pre-emption Rights and Options – Part 2

[This is a continuation of a previous post on the topic. It has been contributed by Ms. Sikha Bansal of Vinod Kothari & Company, who can be reached at]

4.         Legality of option contracts

Option contracts conferring exit opportunities to investors are, in commercial practice, important in view of the growth of funding avenues in the form of private equity, venture capital, infusion of more funds from foreign institutional investors, and involvement of even multilateral agencies like the International Finance Corporation. These funders are not merely “financiers”, these are “strategic investors” and “financial investors”, in the sense that these entities take keen interest in the functioning of the company in which they invest and seek to reap long term benefits from their investment. As such, call options (right to acquire more shares), and put options (right to sell off the shares) serve as tools to meet the purpose as stated above. Though listing of shares is one of the ways which provides easy liquidity to these investors, yet it has its own dimensions and so, these investors have to look out for other ‘options’ to ensure that they do not fall short of exit routes. Also refer to Para 1.2 of the previous article for details.

4.1       Legality under the FDI norms

Notably, the FDI Policy dated September 30, 2011 called for classification of equity instruments with in-built options or supported by options sold by third parties as debt and not equity, thereby requiring compliance with the extant ECB guidelines. However, vide FDI circular dated October 31, 2011, such provision was deleted. Though, prima facie it seemed that such options had been permitted. However, in effect, the ambiguity persisted whether the deletion set out a new policy or merely intended to maintain a status quo. See Para 2 of the previous article for the extant FDI norms on option contracts.

The FDI Policy of 2013 too, is silent on the issue.

With the inclusion of such contracts in the notification, the debate and the ambiguity pertaining to option contracts too comes to a rest. SEBI, however, has imparted ‘conditional validity or legality’ to such shareholders’ options apparently maintaining the view that these contracts are ‘derivatives’ (discussed later). Hence, as it appears, any such contract, i.e. any right to call or put a share in the case of a listed company, is invalid, unless the contract satisfies the conditions stipulated in the notification. However, it is crucial to note here that mere right of a shareholder to sell shares is not a ‘derivative’, as discussed in Para 3.2 of the previous article.

4.2       The Law henceforth

As can be deduced from the discussion in the foregoing paragraphs, the precise point of law is: contracts for purchase or sale of securities pursuant to exercise of an option are invalid and yet impermissible, if these contracts fail to satisfy the three cumulative conditions set forth in the notification.

However a significant question here is: when does the illegality arise? The answer can be inferred from the reading of the conditions. Requirement of a minimum holding period of one year and actual delivery of underlying securities implies that the illegality will arise only at the time of exercising the option, i.e. if the underlying securities are disposed of prior to one year or if the underlying securities are not delivered at the time of exercise of the option.

Another curious question is whether such illegality can be avoided using Section 18A of SCRA, which imparts validity to contracts in derivatives provided these are traded on a recognised stock exchange and are settled on the clearing house. As discussed later, SEBI has treated these contracts as derivatives and exempted these from the scope of Section 18A. So, these contracts fulfilling the stipulated three conditions need not comply with Section 18A. However, as the author views, even if these contracts do not comply with any of the conditions but comply with Section 18A, these would not be rendered invalid, since fundamentally these contracts have been treated as ‘derivatives’ by the regulator.

4.3       Significance of the conditions

In the previous article, it has been remarked,

“If the intent of the put option is only to ensure the exit of a shareholder or section of shareholders, it is merely a matter of private treaty between shareholders. However, if a put option effectively works to guarantee a lender’s rate of return to an investor, it has the effect of transforming an investment into a de facto loan, which may be defeating the distinction between FDI and ECB under foreign exchange regulations.”

The conditions imposed under the notification seem to assert our opinion: the requirement of minimum holding period of 1 year, and settlement by way of actual delivery of securities intend to curb speculation and ensure that the option is only to facilitate the exit of shareholders, and no more.

5.         “Notwithstanding” certain provisions of SCRA

The notification stipulates that the contracts of pre-emption and contracts for sale/purchase of securities pursuant to exercise of an option

“shall be valid notwithstanding anything contained in section 18 A read with clause (d) of sub-section (1) of section 23 of SCRA.”

Section 18A of SCRA is again a non-obstante clause which imparts validity and legality to the contracts in derivative with the pre-conditions that the same are traded on a recognised stock exchange and settled on the clearing house of the recognised stock exchange. Further, Section 23(1)(d) of SCRA imposes punishment (with imprisonment or fine or both) on any person who  enters into any contract in derivative in contravention of Section 18A.

Instantly what strikes is- a sub-ordinate law overriding a principal law. However, the power of the regulator flows from Section 28(2) of SCRA, by virtue of which, any class of contracts may be specified to be out of the purview of SCRA or any of its provisions by the Central Government[1] by means of a notification in the Official Gazette.

Though the notification seeks to override the stated provision of the principal legislation, yet it is pertinent to note that at the very first place, as we have discussed in our previous article, such option contracts do not assume the nature of derivatives [see Para 3.2 of the previous article]. Therefore, there was no need of express exclusion of such contracts from the purview of Section 18A of SCRA. However, such an express exclusion implies that the regulator still regards the pre-emption contracts and such option contracts as “derivatives” within the meaning given under SCRA.

6.         The Companies Act connection

SEBI, in its press release, states that the notification is in line with the proviso to Section 58(2)[2] of the Companies Act, 2013 (the “Companies Act”) which stipulates “any contract or arrangement between two or more persons in respect of transfer of securities shall be enforceable as a contract".

Section 58(2) of the Companies Act provides for free transferability of shares or interest of a member, in case of a public company. However, the proviso to the section seeks to give recognition to restrictions on transfer in shareholders’ agreements, thereby covering preferences like right of first refusal. Seemingly, the same has been inserted as a result of decision of Division Bench of Bombay High Court in Messer Holdings Limited (supra).

7.         Conclusion

The illegality of options and certain clauses in the shareholders agreements, as held to be such by the regulator till now, could have negative impacts on the whole derivatives market and foreign investment, considering the fact that the investors lay mush stress on “the exit clauses” in the shareholders’ agreement. The move by SEBI can be seen as one welcome move and a positive development.

- Sikha Bansal

[1] The power has been delegated to SEBI. See the notification dated July 30, 1996, issued under Section 29A of SCRA:
[2] Section 58 of the Companies Act has come into force with effect from September 12, 2013. See the commencement notification here:

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