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]
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
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]
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
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
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
”). 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
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.
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
[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.

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

  • 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.

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