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.
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.
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 Through this, SEBI has rescinded its previous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
delivery contracts are permitted, consistent with the previous position;
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.
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.
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
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.
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.
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.
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.
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.
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
current move is welcome as it rectifies a previously ambivalent and restrictive
legal regime. This will augur well to investors as well as companies requiring
capital. There may very well be issues regarding the specifics of the recent
notification and the conditions imposed therein, but the overall development is
positive in nature.