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 [email protected]]

In our elaborative article titled, Exit
Options in Equity Investments in India: Recent Issues on Legality

(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aforesaid mentioned notification has been rescinded recently, and SEBI has now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

mentioned, SEBI, vide Notification No. SO 184(E) dated 1 March
[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.
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
, 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
SEBI, vide its Notification dated October
3, 2013
(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
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

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
– government securities,
– gold related securities,
– money market securities, 
– contracts in currency
– interest rate derivatives and
– ready forward contracts in debt

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
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
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]

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.

1 comment

  • 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??

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