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 corplaw@vinodkothari.com]

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: http://www.sebi.gov.in/acts/act02b.html
[2] Section 58 of the Companies Act has come into
force with effect from September 12, 2013. See the commencement notification
here: https://indiacorplaw.in/wp-content/uploads/2013/10/CommencementNotificationOfCA2013.pdf

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.

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