Apart from dealing with specific issues relating to the facts of MCX’s application to commence the business of a stock exchange, the Bombay High Court’s judgment introduces greater clarity regarding the enforceability of options in securities of Indian public unlisted companies.
The court was concerned with two issues pertaining to buyback and option arrangements that were entered into between certain shareholders of MCX. The first pertains to the lack of disclosure of these arrangements to SEBI. The Court found that these arrangements should not have been withheld by the company (and its shareholders) from SEBI, particularly in the context of a stock exchange that also performs a certain regulatory role. The second pertains to the legal validity and enforceability of buyback and option arrangements under law, more specifically the Securities Contracts (Regulation) Act, 1956 (SCRA). This post focuses on the second aspect that relates to substantive aspects of the enforceability of options in securities.
The Court’s ruling on this count may be divided into three parts:
(i) whether options in securities constitute a forward contract that is illegal;
(ii) whether the SCRA applies to unlisted public companies; and
(iii) whether the options violate s. 18A of the SCRA as they are not traded and settled through a stock exchange.
As to the first issue, there appears to be a difference in the characterization of the transaction by SEBI in its order of 23 September 2010 and subsequent submissions to the High Court. Although SEBI’s order proceeds on the basis that the arrangements involved a firm buyback of shares, subsequent determination indicates that these were only “options” and not firm arrangements in the nature of forward contracts. The High Court came to the conclusion that what is proscribed under the SCRA are firm buyback contracts (or forward contracts), and not options. The distinction between the two types of arrangements has been carefully considered by the court as follows:
75. In a buy back agreement of the nature involved in the present case, the promissor who makes an offer to buy back shares cannot compel the exercise of the option by the promisee to sell the shares at a future point in time. If the promisee declines to exercise the option, the promissor cannot compel performance. A concluded contract for the sale and purchase of shares comes into existence only when the promisee upon whom an option is conferred, exercises the option to sell the shares. Hence, an option to purchase or repurchase is regarded as being in the nature of a privilege.
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77. The distinction between an option to purchase or repurchase and an agreement for sale and purchase simpliciter lies in the fact that the former is by its nature dependent on the discretion of the person who is granted the option whereas the latter is a reciprocal arrangement imposing obligations and benefits on the promissor and the promisee. The performance of an option cannot be compelled by the person who has granted the option. Contrariwise in the case of an agreement, performance can be elicited at the behest of either of the parties. In the case of an option, a concluded contract for purchase or repurchase arises only if the option is exercised and upon the exercise of the option. Under the notification that has been issued under the SCRA, a contract for the sale or purchase of securities has to be a spot delivery contract or a contract for cash or hand delivery or special delivery. In the present case, the contract for sale or purchase of the securities would fructify only upon the exercise of the option … in future. If the option were not to be exercised by them, no contract for sale or purchase of securities would come into existence. Moreover, if the option were to be exercised, there is nothing to indicate that the performance of the contract would be by anything other than by a spot delivery, cash or special delivery.
In arriving at this conclusion, the court relied on an earlier decision of the Bombay High Court in Jethalal P. Thakkar v. R.N. Kapur, AIR 1956 Bom 74. Although there was a subsequent decision of the single judge to the contrary in Niskalp Investments and Trading Company Ltd. v. Hinduja TMT Ltd. (2008) 143 Comp. Cas. 204 (Bom), that was not considered as it did not “advance the discourse” for it was “rendered on a summons for judgment in a summary suit”.
Certain observations of the court also indicate that where shares are dealt with through the depository system, then that would automatically be treated as “spot delivery” as the definition of that expression permits such treatment. For example, the Court observes:
Where securities are dealt with by a depository, the transfer of securities by a depository from the account of a beneficial owner to another beneficial owner is within the ambit of spot delivery.
While this is helpful in advancing the cause of enforceability of options by ensuring that the shares are held in dematerialized form, it is possible to push the envelope a further to argue that the same principle should even apply to a firm buyback arrangement or forward contract, as it would be treated as a “spot delivery” contract merely by virtue of the securities being held in dematerialized form and transferred through the depository. This aspect has not been considered by the Court expressly, but it might be a plausible argument through logical extension of what has been expressed by the court.
As to the second issue, the Court considered the available case law on whether the SCRA encompasses public unlisted companies as well as listed ones. On this question, the Court has relied upon the Supreme Court’s rulings in Naresh K. Aggarwala v. Canbank Financial Services Ltd. (2010) 6 SCC 178 and Bank of India Finance Ltd. v. The Custodian AIR 1997 SC 1952 to suggest that the SCRA applies even to public unlisted companies. Hence, the scope and applicability of that continues to be quite wide in nature.
The third issue pertains to whether options can be traded only on the stock exchange, or whether they can be entered into privately on a negotiated basis. This is in view of s. 18A of the SCRA which provides that contracts in derivatives are legal only if they are traded on a recognized stock exchange. The Court did not pronounce its opinion on this issue because it was not advanced initially in the show cause notice of SEBI, and was raised only in subsequent submissions.
I have had occasion to consider the enforceability of options in securities in some detail in this paper, which has now been published in the NUJS Law Review, where I argued that (i) “options” are not forward contracts, they are different from buyback arrangements, and hence should be enforceable under the SCRA; (ii) the SCRA should apply only to listed companies and not to public unlisted companies; and (iii) s. 18A should not apply to physically-settled options that are entered into over-the-counter. The Bombay High Court in the MCX case has vindicated the stance on the first issue, rejected the approach on the second issue (primarily due to the existence of Supreme Court’s rulings on the point, which only it can overturn) and refused to decide on the third issue due to procedural considerations.
The Bombay High Court’s judgment represents a step forward in resolving the issue pertaining to the enforceability of options in securities that has continued to vex corporate practitioners for over two decades now. However, it is difficult to assume that the last word has been said on the matter. Certain issues, such as the impact of s. 18A, still remain. While the significance of the legal issues raised in this case may very well command an appeal to the Supreme Court, much of this ambivalence can be ended by appropriate notification or regulation by SEBI under SCRA to induce the necessary clarity rather than to place the onus on the judiciary to resolve them.