The enforceability of pre-emption rights and put and call options in securities of Indian companies has been fraught with difficulties for a number of years. These have been discussed in detail in this paper, with arguments made for streamlining these provisions to recognise such rights and options in investment agreements.
Although the Securities and Exchange Board of India (SEBI) had been actively considering proposal to ease the restrictions on the enforceability of these provisions, matters picked up steam only a few months ago when the Law Ministry decided to permit options in investment agreements.
This decision of the Government has now been implemented through a notification issued by SEBI yesterday. Through this, SEBI has rescinded its previous notification of March 1, 2000 that prohibited contracts other than spot delivery contracts or those entered into through the stock exchange mechanism. Accordingly, SEBI now permits various types of pre-emption rights and put and call options, but subject to certain conditions. The new position is as follows:
1. Spot delivery contracts are permitted, consistent with the previous position;
2. Sale and purchase contracts on securities are permitted so long as they are in accordance with securities regulations and stock exchange regulations and by-laws. These would include transactions, including in derivatives, which are carried out through the stock exchange.
3. Contracts for pre-emption including right of first refusal (ROFR) or tag-along or drag-along rights contained in shareholders agreements or articles of association are allowed. Note that this is only an inclusive provision and is not exhaustive of all the types of provisions in the agreements or articles that can be enforced. This enables investors to exercise their exit rights in companies through the above mechanisms that are generally recognised. No conditions are attached for the exercise of these rights.
4. Put and call options contained in shareholders agreements or articles of association are treated somewhat differently from pre-emption rights discussed in item 3 above. The reason is that the exercise of options is subject to certain conditions:
(a) The underlying securities that are the subject matter of the options must have been held by the relevant party for a minimum period of 1 year from the date of entering into the option contract. This seems to be to ensure that options are not short-term in nature and are permitted only when the holding of the securities is for a considerable period of time. The genesis for the erstwhile prohibition on options was to prevent speculation in securities, and this approach is imposing a minimum 1-year term on the options is consistent with that philosophy.
(b) The pricing of the options and the exercise is to comply with applicable laws. More specifically, the notification states that all contracts permitted through it must comply with the provisions of the Foreign Exchange Management Act, 1999. This applies when options and pre-emption rights are granted by or in favour of a non-resident investor. Where the exercise of the option or pre-emption results in a transfer of securities between a resident and a non-resident investor, then the idea is that the relevant pricing norms imposed by the Reserve Bank of India (RBI) must be complied with. This is significant for foreign investors to take into account. Merely because SEBI has now conditionally permitted options, it does not mean that parties have complete freedom in exercising the options. The pricing is still regulated by the relevant RBI norms, and hence the commercial understanding between the parties regarding the exercise price will be subject to these regulatory constraints.
(c) The new permissible regime applies only to physically-settled options where there is an actual delivery of the underlying securities. It does not cover cash-settled options, which are essentially contracts for differences. This is understandable given the philosophy of the legal regime to curb speculation. Moreover, investment agreements (where investors seek exit rights) usually relate to an actual sale or purchase of securities rather than a contract for differences, and hence this should not pose difficulties for customary investment transactions.
5. This new permissible legal regime applies only prospectively, and does not “affect or validate any contract which has been entered into” prior to the date of the notification. Hence, past contracts with pre-emption rights or put and call options will not be “grandfathered”. One possibility to overcome this restriction would be for parties to existing contracts to re-execute them as of a future date.
6. Finally, an explanation to the notification states that the contracts specified in the notification would be valid without regard to anything contained in section 18A of the Securities Contracts (Regulation) Act, 1956, which refers to exchange traded contracts. In other words, such pre-emption rights and option contracts would be permissible even though they are entered into on an over-the-counter (OTC) basis and not traded on the stock exchange.
Overall, SEBI’s notification represents a momentous regulatory change. Companies, investors and their advisors have been grappling with concerns regarding the enforceability of pre-emption rights and options for nearly two decades now. The oddity of the situation was the expansive application of SEBI’s previous regime that applied not only to listed companies but also to unlisted public companies. Moreover, while speculation was the concern, it seemed to encompass genuine transactions as well, making customary investment transactions inefficient in terms of structuring (particularly of exit options).