Saturday, January 11, 2014

Guest Post: RBI Circular on ‘Options’

[The following post is contributed by Parag Bhide, who is a Principal Associate at Universal Legal, Mumbai]

Finally, Foreign Investors investing into India are able to include ‘options’ in their investment agreements. The Reserve Bank of India (“RBI”), through its circular dated 9 January 2013 (“Circular”) has legitimized inclusion of options/right to exit in the Investment Agreements.[1]


The put/call options were omnipresent in the Investment Agreements (governing joint ventures, private investments and the like) before such options faced the glare of Indian regulators. Indian regulators like the RBI, the Securities and Exchange Board of India (“SEBI”) were uncomfortable in permitting such options in the Investment Agreements, albeit, for different reasons and rationale of each regulator.

Stand taken by SEBI

The objection of SEBI to options is from the perspective of provisions contained in the Securities Contracts (Regulation) Act, 1956 (“SCRA”). As per SEBI, since the SCRA permits derivatives ‘only if they are entered into on stock exchanges’, such contracts between the private parties are violative of Section 18A of SCRA. Hence, any private contractual arrangements (involving grant of options) exclusively entered into between parties (and not through exchange platform), is in violation of Section 18A of the SCRA.[2] The foregoing interpretation appears to be ‘farfetched’ while disallowing put and call options in case of unlisted companies.[3]

However, SEBI subsequently permitted, inter alia, contracts consisting of pre-emption rights including but not limited to right of first refusal, or tag-along, or drag along rights and other such pre-emptive rights contained in shareholder agreements or articles of association of companies or other body corporate instruments; clauses in shareholder agreements or articles of association of companies or other body corporate instruments, for purchase or sale of securities pursuant to exercise of an option contained therein to buy or sell the securities under certain specified circumstances.[4]

RBI’s Point of View

The RBI has also been uncomfortable with inclusion of options in Investment Agreements. However, the rationale behind RBI’s view has been different. RBI viewed such ‘options’ as modes of assuring exit to a foreign investor within a specified period, thereby defeating the spirit of equity instruments and making them akin to debt instruments.

Given the stringent law governing External Commercial Borrowings (“ECBs”) in India which sets out permitted sectors and conditions for availing ECBs (like all cost ceilings, end use requirements and other conditionalities), RBI viewed such options as a mode of circumventing the law governing ECBs.

DIPP Announcement

Considering the viewpoints (as explained above) of different regulators, the Department of Industrial Policy and Promotion, Government of India (“DIPP”), on 30th September 2011, announced that all investments in securities with in-built options or those supported by options sold by third parties will be considered as ECBs.[5] However, the industry raised serious objections against the foregoing announcement of DIPP and subsequently, on 31st October 2011, the DIPP deleted the said para from the Consolidated FDI Policy Circular (2 of 2011).[6]

RBI Notification permitting options

Now, the RBI, vide the Circular dated 9 January 2013 has legitimized inclusion of options/right to exit in the Investment Agreements subject to certain conditions.[7] The relevant para of the Circular is reproduced below:
“It has now been decided that optionality clauses may henceforth be allowed in equity shares and compulsorily and mandatorily convertible preference shares/debentures to be issued to a person resident outside India under the Foreign Direct Investment (FDI) Scheme. The optionality clause will oblige the buy-back of securities from the investor at the price prevailing/value determined at the time of exercise of the optionality so as to enable the investor to exit without any assured return.”

The conditions, prescribed by the RBI are summarized hereunder:

1. There is a minimum lock-in period of 1 (one) year or a minimum lock-in period as prescribed under FDI Regulations, whichever is higher (“Lock-in Period”). The Lock-in Period shall be effective from the date of allotment of such shares or convertible debentures.

2. The non-resident investor exercising option/right shall be eligible to exit without any ‘assured return’ as under:

2.1. In case of a listed companies, the non-resident investor shall be eligible to exit at the market price prevailing at the recognised stock exchanges; and

2.2. In case of unlisted company, the non-resident investor shall be eligible to exit from the investment in equity shares of the investee company at a price not exceeding that arrived at on the basis of Return on Equity (“RoE”) as per the ‘latest audited balance sheet’.[8]

2.3. Any agreement permitting return linked to equity, as above, shall not be treated as violation of FDI policy/FEMA Regulations.

2.4. Investments in Compulsorily Convertible Debentures (CCDs) and Compulsorily Convertible Preference Shares (CCPS) of an investee company may be transferred at a price worked out as per any internationally accepted pricing methodology at the time of exit duly certified by a Chartered Accountant or a SEBI registered Merchant Banker. The guiding principle would be that the non-resident investor is not guaranteed any assured exit price at the time of making such investment/agreement and shall exit at the price prevailing at the time of exit, subject to Lock-in Period, as applicable.


The Circular issued by the RBI is a welcome step, thereby giving a much required green signal clarifying the legal position on options. Further, maintaining its stand against the ‘debt alike instruments’, the RBI has also specifically disallowed the assured return commitment towards investors.

While the positive action of RBI has opened additional exit routes to foreign investors, further clarity is needed on the RoE linked valuation (in case of equity shares), as such valuation would take into account only historic performance and not the future prospects.

- Parag Bhide

[1] A. P. (DIR Series) Circular No. 86 dated 9th January 2014.

[2] In the infor­mal guidance given by SEBI to Vulcan Engineers Limited, SEBI, on 23rd May 2011 opined that the put and call options in securities would not qualify as spot delivery contract as defined under Section 2(i) of SCRA. Further, such options would not qualify as legal and valid derivative contract in terms of Section 18A of the SCRA as it is exclusively entered between two parties and is not a contract traded on stock exchanges and settled on the clearing house of the recognized stock exchange. (The foregoing informal guidance is available at

[3] SCRA is applicable in case of listed public companies. In case of private limited companies, SCRA becomes inapplicable.  However, based on the precedents, it can be concluded that SCRA also applies to unlisted public companies. Although, the foregoing view seems to be unjustified in case of unlisted public companies, which do not intend to list their shares on recognized stock exchanges, it remains the position of law. 

[4] SEBI Notification No. LAD-NRO/GN/2013-14/26/6667 dated 3rd October 2013.

[5] Para of the Consolidated FDI Policy Circular (2 of 2011) dated 30th September 2011.

[6] DIPP Press Release No. 5(19)/2011-FC-I dated 31st October 2011 (The foregoing press release is available at

[7] Ibid.

[8] As clarified in the Circular, the RoE shall mean Profit After Tax / Net Worth. Net Worth would include all free reserves and paid up capital.

1 comment:

Casey said...

Any thoughts on why the distinction between equity shares and convertible instruments? The RoE concept seems regressive and may be an inappropriate method of valuation for a number of sectors.