SEBI finally resolves an age-old self-created problem SEBI has finally set at rest, substantially though not fully, a controversy that affected for decades some core issues in Shareholders Agreements and related agreements/structures. An age old provision in the form of a circular existed that was meant to prevent certain ills but ended up affecting innumerable agreements between two or more groups of shareholders and others. A brief introduction of the issue is first necessary to understand what the problem was and what SEBI has now provided.
What was the problem?
Take an example of a situation where such a provision created hurdles. When two or more groups get together in a company, to control and run it together, it is common and even inevitable that they will agree that one group will not exit without the other having a say. Thus, if Group A wants to sell its shares, Group B would want certain safeguards/rights. It would require Group A to give what is known was Right of First Refusal. This means that if Group A is getting an offer to acquire its shares at say, Rs. X per share, then Group B would have right to buy the shares at the same price. In other words, it has a right of pre-emption. Of course, Group B could choose not to buy and let the shares be sold to the offering party. At times, they may agree that on completion of certain conditions, one group (or a third party, say an executive) would have a right to acquire a certain number of shares. One could go on with more such examples but, in essence, rights are given over to one person to acquire another person’s shares in the future. Similar rights could be given to a person to sell its shares.
The law makers had a certain concern on an entirely unrelated issue. Considering the evils of unregulated trading in shares (including what is known as dabba trading in common parlance) it was decided that trading in securities otherwise than on regulated and recognized stock exchanges should not be permitted. Thus, trading – or even contracting to buy/sell – securities except on a recognised stock exchange was made null and void. Thus, such a contract was not enforceable. The only real exception (apart from certain territorial exceptions) to was “spot transactions”. This covered a contract of purchase and sale of securities where the delivery/payment was spot – which was effectively defined to be that the delivery of shares and payment was to be made within one day of the contract.
The law as so framed ensured that forward/futures/ options trading in securities could not be carried out without being regulated. However, a simple transaction of private sale and purchase of shares and other securities on ready payment/delivery basis was exempted.
The wording of this law, however, had a peculiar consequence. It meant that no contract of sale/ purchase of securities could be entered into unless it fell into the very narrow exempted category. For most practical purposes, one could not enter into a valid agreement to buy/sell shares in the future. Or enter into an agreement where involving postponement of the payment of consideration and/or delivery of the securities beyond one day. As joint ventures, private equity, co-promoted companies, etc. became increasingly common, this became a serious concern. Parties entering into such agreements could not bind each other with such basic commercial safeguards. This was despite the fact that almost all of such agreements could not even remotely affect public interest, being entered into by informed parties on a negotiated basis without any intention of trading.
In practice, this problem was dealt with parties by often being in denial or half-baked structuring or even sheer ignorance. Some legal counsels even opined that, structured in a particular way, the notification did not apply to private agreements. The reality, however, was that even in the most optimistic scenario, often, there was concern that, if put to test, many of such clauses in agreements may not be held valid. Thus, what was referred to euphemistically as a “calculated risk” was taken. The fact that Supreme Court, other courts and SEBI held many of such agreements to be unenforceable worsened matters (the various decisions and their legal basis can be subject for a separate detailed article).
The matter became more complicated when this issue spilled over to other laws including laws regulating foreign exchange.
SEBI’s recent circular gives relief – with some conditions
Finally, on 3rd October 2013, SEBI issued a circular withdrawing the earlier notification and allowing parties to enter into agreements for purchase/sale of shares, though with certain conditions which are fairly reasonable. Let us consider which of such contracts are exempted and under what conditions.
The first two exemptions are as expected and continuing ones. “Spot Delivery Contracts” are exempted. Purchase or sale of securities/derivatives on stock exchanges in accordance with law and bye-laws, etc. of such exchanges are also exempted.
Next exempted category is “contracts for preemption including right of first refusal, or tag-along or drag- along rights contained in shareholders agreements or articles of association of companies or other body corporate”. Thus, all contracts of pre-emption are exempted, including the specified ones such as right of first refusal, etc. These may be contained in the agreements between shareholders and/or incorporated in the articles of association of the company.
Then come certain “options” in agreements between shareholders (or contained in the articles of association). Such options provide a right to one person to buy or sell shares. On exercise of such options, the actual purchase/sale of shares is effected. Such agreements are also exempted, subject, however, to certain conditions. Firstly, the securities underlying such options should have been held continuously for at least one year by the selling party. This is effectively a lock-in period. Secondly, the price/consideration for such purchase/sale of shares should be in compliance with prevailing laws. Finally, the contract, i.e., the purchase/sale is settled by actual delivery of the underlying securities.
The circular makes it clear that the contracts will continue to have to adhere to FEMA and Regulations/Rules issued thereunder. FEMA has other policy considerations and hence such agreements particularly with parties across the border would require such compliance.
Will the relaxations apply to existing agreements?
An interesting provision is made for agreements for purchase/sale of shares existing on the date of this circular. It is clarified that this circular shall neither affect nor validate agreements existing immediately prior to the date of the circular. In other words, all such existing agreements shall continue to be subject to the earlier law. Only those contracts having such clauses and which are entered into on or after the date of this circular would benefit from the relaxations made in it, subject of course complying with the conditions stated therein.
There have been views expressed that parties could merely re-execute such contracts as of a date after the date of such circular. This sounds like a fairly simple solution to the thousands of agreements existing as on such date, though one wonders whether it is simplistic too. The practical hurdle is whether all the parties concerned would readily agree to re-execute such past agreements. In practice, often relations may have soured between the parties who may want to re-negotiate certain terms of the agreement if it has to be re-executed. Obviously, though the party entitled to the rights may be keen, the party who is subject to the obligations may not readily agree. Then there is a commercial reality that was often observed in practice. Many parties entered into some version of such agreements knowing quite well that they are likely to be unenforceable. Hence, they considered the likelihood of being required to act upon it fairly remote and considered that if at all such transactions were to be executed, the parties could consider the offered terms and generally the reality at that time. The party entitled to the rights too may not have really believed that it would actually get them. Clearly, these parties never intended such agreements to have unqualified binding force and they may not agree to re-execute them to give them such force. Thus, the parties would want to re-negotiate the contract instead of merely printing out a copy and re-executing the same today.
Applicability to other laws for certain contracts
The circular also clarifies that as far as government securities, gold related securities, money market securities, contracts in currency derivatives, interest rate derivatives and ready forward contracts in debt securities entered into on the stock exchange are concerned, they shall be in accordance with various specified laws such as securities laws, banking laws, FEMA, etc.
Anomalous provision in Companies Act, 2013
In this context, it is necessary to discuss a strange provision in the recently notified Companies Act, 2013. Section 194, which incidentally has been notified as to have come into effect, prohibits certain contracts by directors/key managerial persons of companies. The specified contracts are rights (or a right exercisable at option of such person) to call for delivery or make delivery of a specified quantity of shares/debentures, at a specified price and within a specified time. It appears that the intention is to prohibit contracts of futures/options. While this is consistent with the existing provisions under the SEBI Regulations relating to prohibition of insider trading, this provision is too widely worded. The SEBI Regulations are intended to prohibit directors/officers/designated employees from entering into derivatives transactions of their companies. However, the scope of section 194 is very broad. It is a blanket ban on all agreements giving any right or option to acquire/sell shares. Further, the section applies to all companies – listed, unlisted or even private. It does not even give exemption to employees’ stock options. Thus, despite the relaxation by the circular, this ill-advised provision in the Act can present problems. On the other hand, it applies only to directors/key managerial persons and not others including other promoters or promoter companies.
Curiously, the Explanation to this section seems to modify its scope. Firstly, it states that it would apply to those shares/debentures where the concerned person is a whole -time director and not merely a director. Secondly, the shares/debentures may be of the employer company or its holding company or its subsidiary. Even more curiously, the initial part of the section refers also to “associate” companies. Further, the ban in the section is on “buying” such rights and one thus wonders whether such rights granted to employees or otherwise forming part of contracts are also covered. The section is an example of bad drafting. To summarise, however, this provision will create hurdles in case of whole-time directors/key management persons in entering into agreements to buy/sell shares in the future or acquire options for such buy/sell of shares.
To conclude, SEBI has finally provided relaxation to genuine contracts between parties that faced the possibility of being treated as impermissible under SEBI regulations though they did not affect public interest.
