Put Options: Putting Up with Foreign Exchange Regulation

[Ryan Joseph is a 3rd year B.B.A., LL.B. (Hons.) student at Jindal Global Law School]

A decision of the Madras High Court in January this year in GPE (India) Limited v. Twarit Consultancy has added to the controversial debate over the enforcement of put options that guarantee assured returns. The High Court toed the line with other courts and upheld an arbitral award, notwithstanding the contention of the Reserve Bank of India (RBI) that such awards violate rules promulgated under the Foreign Exchange Management Act, 1999 (FEMA). This post will analyse the prohibition on put options guaranteeing assured returns under the FEMA (Non-Debt Instruments) Rules, 2019 and the exceptions that various judgments have carved out. The post will then highlight the inefficiencies in such indirect enforcement to establish that enforcement of put options with guaranteed return constructs will never be commercially viable without regulatory support.  

Prohibition on Put Options with an IRR Construct

A put option is an agreement that creates a right in favour of the holder of a security to sell the security at a particular price at a particular time. This is a commonly used exit mechanism in private equity (PE) and mergers and acquisitions (M&A) deals. Investors often ask for the put option to have an internal rate of return (IRR) construct. IRR is a pricing mechanism that enables investors to determine the exit price they would require to achieve a particular return on their investment. When incorporating such constructs, the put option would read, “the acquirer shall have a right to sell the securities at a price equal to the Investors Capital plus a post-tax IRR of 19%”. Such clauses are drafted to hedge investment risks by guaranteeing an exit price that the investor could expect in case all other exit modes turn out inefficacious.

Notwithstanding their commercial utility, their incorporation in agreements leads to legal complications as India’s foreign investment regulations prohibit such agreements. Rules 9(5) and 21(2)(c)(iii) of FEMA (Non-Debt Instruments) Rules, 2019 govern the pricing mechanism of equity shares transferred to a person resident in India from a person resident outside India. It states that the exit price provided to investors cannot exceed the valuation carried out according to any internationally accepted pricing methodology for valuation on an arm’s length basis certified by a chartered accountant. This value is called the fair market value (FMV). The explanation to the rule adds that a person resident outside India cannot be guaranteed an “assured exit price” when investing in the company. This rule poses difficulties for enforcing put options with an IRR construct as that guarantees the investor an assured exit price. Quite often, such pre-determined value exceeds the FMV at the time of exit.

Regulatory Motive

The regulatory motivation for prohibiting such constructs is that they tend to blur the difference between debt and equity. The single most differentiating marker of equity from debt is equity risk. Unlike a debt, where the risk is low because the creditor is legally owed the dues, the returns on debt transactions (the interest rate) are also low. Considering the high risks of an equity transaction, where the investor has no right over a return on its investment, the returns account for such risks and are far higher than those in a debt transaction. However, the IRR constructs allow parties to agree to a pre-determined exit value which assuages equity risks causing the regulator to view such transactions as debt dressed as equity.

From a regulatory perspective, huge ramifications flow from the morphing of foreign investment into foreign debt. Foreign investments are positive infusions of capital into the domestic economy that can spur aggregate demand and widen the cyclical flow of money. Foreign debt, on the other hand, makes the domestic economy vulnerable. If Indians were to increase their external borrowing, the dollar’s value would rise, putting downward pressure on the value of the rupee, which would make the repayment of the debt in dollar more difficult as one needs more rupees to repay every dollar. If one were to borrow more to finance repayment, it would once again put a downward pressure on the rupee leading to a cycle of doom. Therefore, the RBI is extremely cautious with foreign debt and regulates it far more stringently than it regulates foreign investment.

Commercial Interest

Corporate India and foreign investors, on the other hand, have very strong reasons that justify the need for put options in investment agreements. Investors take a considerable amount of risk when investing in international markets that they are not familiar with. The geographical distance, regulatory differences and variations in language, culture, and the way of life act in conjunction with each other to severely increase the risk of investing in India. These risks are further accentuated when investing in startups. Managing these risks inflates the monitoring costs for foreign investors and swells the cost of investment in India leading to lower returns from their investments.

Although other exit routes, such as going for an initial public offering (IPO), are available to foreign investors and, more often than not, these routes are preferred over exercising put options, there is no guarantee that such exit options will always be commercially viable. For instance, an investor who targeted to exit during the market downturn caused by Covid-19 might have found it very difficult to use the IPO route owing to the lacklustre performance of capital markets. Similarly, companies must navigate a complex regulatory pathway before going for an IPO. Put options with an IRR construct play an instrumental role in such circumstances as they assure the foreign investor of a basic return on their investment, notwithstanding market conditions.

The tussle between regulatory and commercial interests has made the enforcement of put options a very sensitive area for Indian corporates. Owing to their commercial necessity, notwithstanding the prohibitions placed by the RBI, commercial workarounds have been found to enforce such clauses.

Downside Protection

In the case of NTT Docomo, Inc. v. Tata Sons Ltd, the shareholders’ agreement (SHA) contained a clause stating that Tata Sons would either find a buyer for NTT Docomo’s shares at a predetermined price (“sale price”) or buy the shares back themselves. Unable to find buyers, Tata had to repurchase the shares. However, the FEMA rules allowed Docomo to receive only the “fair market value of their equity, which was lower than the sale price. Tata sought RBI’s permission to pay Docomo the sale price, but the permission was denied. The dispute went to arbitration, resulting in an award of $1.7 billion for Docomo. The RBI challenged the award’s enforceability, claiming a violation of FEMA rules. The Delhi High Court, while upholding the arbitral award, ruled that the mere fact that the SHA had a clause that mandated Tata to offer Docomo an exit at the sale price cannot by itself be a ground to conclude that the clause violates FEMA Rules. The SHA provided numerous other modes of exit, and Tata could have used any of those. However, upon failing to have done so, Tata was forced to use a particular mode of exit. Furthermore, Docomo’s total investment was $2.5 billion, of which the sale price was a mere $1.7 billion, half the investment value. Such a construct does not grant Docomo an “ascertained return” but acts as a downside protection construct wherein Docomo’s investment value is protected from dipping below a certain value.

Repayment of Dues as Damages

In the case before the Madras High Court in GPE (India), the investors in Haldia Coke and Chemicals Private Limited had a put option that required the promoters of Haldia Coke to purchase or cause the purchase of the shares held by the investors at an IRR of 24% of the amount invested. The promoters sought to resile from the obligation by relying on rule 21 of the FEMA (Non-Debt Instruments) Rules, 2019. However, a tribunal of the Singapore International Arbitration Centre (SIAC) found in favour of the investors and passed an award requiring the performance of the put option. During the enforcement proceedings before the Madras High Court the promoters challenged the enforcement on the grounds that the award violates the public policy of India as the put option provides for an exit at a guaranteed price which is proscribed by rule 21.

Relying on Vijay Karia v. Prysmian Cavi, the Madras High Court ruled that a rectifiable violation of FEMA does not tantamount a violation of the public policy of India. Further, the Court went on to agree with the arbitral award and ruled that even if the put option in the share subscription and shareholders agreement is void, the promoters who while executing the contract represented that the covenants are in conformity with Indian law are liable to compensate the investor through damage equivalent to the entire unpaid sale consideration and that the investors may then remit the sum subject to the approval of RBI.

The Delhi High Court in Shakti Nath v. Alpha Tiger upheld an arbitral award on the grounds that the investors did not seek to exercise the put option, rather they were claiming damages under section 73 of the Indian Contract Act. Although the defendants argued that seeking damages amounts to violating the RBI’s prohibition on put options, the Court found that unlike the exercise of a put option, a claim for damages does not violate any RBI regulations, and thus disagreed with the contention.

Provision for Damages in the Articles of Association

When Merrill Lynch invested in Om Logistics, a clause was inserted in the articles of Om Logistics that created a put option in favour of Merrill Lynch whereby the promoters could be required to purchase the allotted securities from Merrill Lynch at a valuation that accounted for an IRR of 25% over the invested amount. In case the strike price exceeds the FMV, the promoters would have to pay the difference over the FMV as liquidated damages.

Enforcement of the Put Option with RBI Approval

In Banyan Tree Growth Cap. v. Axiom Cordages, the Bombay High Court dealt with a matter where the parties had a put option that guaranteed Banyan Tree a guaranteed return of 15% on its investment and upheld the enforceability of such a clause on two grounds. First, that the impugned clause is not inherently violative of FEMA rules. In a put option, the promise to sell shares at a predetermined price activates only when the investor accepts the investee’s put option. Therefore, until the moment such an offer is made, FEMA Rules have no implications for put options with IRR constructs. Further, the put option was only one amongst numerous other exit routes. Second, even when the put option is exercised, the investor not residing in India can still repatriate monies to the extent of the put options compliance with FEMA rules and, based on the Supreme Court’s ruling in IDBI Trusteeship v. Hubtown, any excess amounts can be kept in a nominee account of the investor in India and the same can be repatriated with RBI’s approval.

The Delhi High Court’s decision in Cruz City 1 Mauritius Holdings v. Unitech Limited established a test on when a put option with an IRR construct can be said to provide a pre-determined price. The construct of the put option in Cruz City was the same as clauses in all other cases; however, its enforcement was made contingent to various other factors. The High Court observed that the option could be exercised only within a specified time and only if the construction was not commenced within the prescribed time. Therefore, it was not an open-ended assured exit option. Based on these findings, the Court enforced the put option but subjected the remittance to RBI approval.

Limitations of Commercial Workarounds

All the judgments named above were widely celebrated and viewed as judgments that crystalise India’s pro-business stance. Regardless, a closer look at the implications of these exceptions indicate that they do not truly help investors exercise their put options. At the outset, a put option can be freely exercised only when the strike price equals or is below the FMV. When the two prices match, it indicates that the company is performing extremely well. It is unlikely that an investor would exercise the put option in such circumstances and would use the IPO route for a better exit. Put options are more of a last resort solution that are useful when no other remedy exists. Their use is envisaged in circumstances when the FMV is far below the strike price; yet due to the regulations they cannot be exercised at that price which compromises their utility. In the NTT Docomo case, since the strike price was 50% less than the actual invested amount, the courts treated the put option as a downside protection. As there are not any more cases that dealt with “downside protection”, the propensity of courts to view put options from this lens is yet to be tested.

Structuring exits by claiming the value through damages in arbitration is a very expensive and time-consuming strategy. The costs of arbitration and overall legal costs amounted for NTT Docomo as cited in the judgment stood at 120,000 GBP and 1,000,000,000 Japanese Yen respectively. When other costs such as pre and post dispute negotiation, enforcement measures, inter alia, the costs will increase considerably. Prima facie the outcomes from GPE (India) or Shakti Nath allow the investor to exit at the desired valuation, the requirement to park value over the FMV greatly hurts the autonomy of the investor. An India-focused fund may not object to the restriction as they can redeploy the funds in India. A joint venture partner or a strategic investor may find the restriction cumbersome as they need to find a new use for the surplus money in India. Moreover, practically it has been noticed that RBI very rarely gives the permission to remit excess sums offshore. In NTT Docomo, the RBI was willing to permit the remittance long before the litigation began. However, the Central Government, which is the final decision-making authority, rejected the RBI’s recommendation to grant an exception.  

It is unlikely that the tussle between the commercial interests and regulatory concerns is going to be resolved anytime soon. This is unfortunate considering that without regulatory support, no matter how much space courts carveout to enforce put options, it will always be commercially inefficient. Therefore, it is of vital importance that a resolution between the two interests is found sooner than later.

Ryan Joseph

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