Introduction
Private Equity Investments and Foreign Direct Investments in nine out of 10 cases, contain an exit option. This may be in the form of a put option whereby the investor has a right/option but not an obligation to sell the shares to the promoter of the investee company in case the company does not give an exit in the form of an IPO or an Offer for Sale or Buyback of the investor’s shares. In some cases, the promoters also have a call option under which, they can buy out the investor at their option. In addition, the investment carries certain pre-emption rights for the investor in the form of Right of First Refusal, Tag Along Rights, Drag Along Rights, etc. This is a standard practice internationally and is something which is not unique to the Indian scenario. Even in India, this has been in vogue for the last several years and the ship was sailing quite smoothly. However, recent change in stance by the SEBI, the RBI and the DIPP and the High Courts have created a very stormy and turbulent climate for private equity/ foreign investment/joint ventures in India. If the issues thrown up by these changes are not resolved urgently, then we may see a severe hit to India’s growth story since most international investors would be wary of investing in such a climate. Let us look at the murky environment which has been created due to these changed regulatory positions.
FDI Policy
Exit options have been a norm in foreign direct investments. However, since the last couple of years the RBI has been taking a view that exit options, such as put and call options, attached to Compulsorily Convertible Debentures/Preference Shares for foreign direct investment are not valid. The view being taken was that a fixed exit option makes the equity instrument equivalent to a debt instrument. Another view advanced by the RBI was that only exchangetraded derivatives are permissible and these option agreements are not exchange-traded. Gradually the RBI extended this view even to options attached to equity shares.
A counter-argument to this view of the RBI was that as long as the pricing guidelines are met on the exercise of the option and there is no fixed rate of Internal Rate of Return/fixed price, the option agreements are valid. If there is no guaranteed exit price and the ultimate price is subject to the prevailing FEMA pricing guidelines, a put or a call option was considered to be valid. Another argument was that if these were debt instruments, then who was the borrower? The foreign investment was in the Company, but the exit option was provided by the promoter. In such an event how can the options be classified as debt?
While this debate was raging, the Department of Industrial Policy and Promotion (DIPP), Ministry of Commerce issued the Consolidated FDI Policy vide Circular 2/2011 on 30th September 2011, which acted like the final straw which (temporarily) broke the camel’s back. This Policy contained a Clause 3.3.2.1, which stated that only equity shares, fully, compulsorily and mandatorily convertible debentures and fully, compulsorily and mandatorily convertible preference shares, with no in-built options of any type, would qualify as eligible instruments for FDI. Equity instruments issued/transferred to non-residents having in-built options or supported by options sold by third parties would lose their equity character and such instruments would have to comply with the ECB guidelines. This bolt from the blue left the industry reeling.
Subsequently, taking heed to the adverse industry reaction, on 31st October 2011, a Corrigendum was issued by the DIPP deleting the above Clause 3.3.2.1. Hence, now according to the FDI Policy, even equity instruments/CCDs/CCPS issued/transferred to nonresidents having in-built options, would qualify as eligible instruments for FDI. Accordingly, they would not have to comply with the ECB Guidelines.
Earlier, there was a question mark over the validity of such options under the FEMA Regulations. However, it is now submitted that in view of the express provision in the FDI Policy banning exit options and its subsequent deletion, the Government’s position on this issue has become clear. For instance, the Supreme Court in the case of V. M. Salgaocar, 243 ITR 383 (SC) held that the fact a provision was introduced in the Income-tax Act in 1984 and subsequently repealed in 1985 showed the legislative intent. Now to take a view that put and call options are not permissible under the FDI Policy/FEMA Regulations is not tenable in the author’s view. One hopes that this is the last see-saw in the FDI Policy/FEMA Regulations and this stand is endorsed by all concerned.
SEBI’s view for listed companies
In addition to the flip-flop in the FDI policy, lately the SEBI has also sought removal of option clauses from Agreements. This stand was taken by the SEBI in the context of listed companies. The SEBI first took this view in the case of Cairn India Ltd.-Vedanta Resources Plc. When Vedanta filed a letter of offer to acquire the shares of Cairn India, the SEBI noticed that there was a put and call arrangement and preemptive rights. The SEBI asked the parties to drop these clauses.
Again, in the Informal Guidance issued by the SEBI to Vulcan Rubber Ltd., the SEBI held that an option arrangement in the case of a listed company is not valid. Option agreements have been around since several years. It is only now that the SEBI has woken up to them and is raising objections. However, these option agreements in the case of listed companies have had a very chequered past which also merits attention. Given below is a brief account of their history in chronological order:
(a) The Securities Contracts (Regulation) Act (‘SCRA’) regulates transactions in securities. This Act prohibits certain type of contracts and permits spot-delivery contracts or contracts through brokers. Spot-delivery contracts have been defined to mean contracts in securities which provide for the delivery and payment either on the day of the contract or on the next day.
(b) As far back as in 1955, the Division Bench of the Bombay High Court in the case of Jethalal C. Thakkar v. R. N. Kapur, (1955) 57 Bom. LR 1051 had upheld the validity of an option agreement in the context of the erstwhile Bombay Securities Contracts Control Act, 1925 (the Act in force prior to the SCRA). The Court held that an option agreement is a contingent contract and not a contract at all till such time as the contingency occurs. Hence, it is a valid contract and enforceable in law.
(c) By a 50-year old Notification (SO 1490), issued in 1961, the Central Government had specified that contracts for pre-emption or similar rights contained in the promotion or collaboration agreements or in Articles of Association of limited companies would not be covered within the purview of the Act. Thus, as far back as in 1961, the validity of pre-emptive and other rights were upheld.
(d) Subsequently, in June 1969, the Government issued another Notification u/s.16 of the SCRA stating that all contracts for sale and purchase of securities other than spot-delivery contracts were prohibited. The 1969 Notification did not rescind the 1961 Notification.
(e) The 1969 Notification was superseded by a Notification dated 1st March 2000, which divided the power to regulate various contracts in the securities between the SEBI and the RBI. The sum and substance of the 2000 Notification was on the lines of the 1969 Notification.
(f) Section 20 of the SCRA, which specifically prohibited options in securities was deleted w.e.f. 25-1-1995. Even the preamble prohibiting options was deleted. It is submitted that these deletions specifically show that the legislative intention was to permit options after 1995.
(g) In 2005, in a Summons for Judgment No. 766 of 2004 (in Summary Suit No. 2550 of 2004) a Single Judge of the Bombay High Court held in the case of Nishkalp Investments & Trading v. Hinduja TMT Ltd., that an agreement for buying back the shares of a company in the event of certain defaults was hit by the definition of spot-delivery contract under the SCRA and hence, unenforceable. It distinguished the Division Bench’s judgment in the case of Jethalal Thakkar (supra) on the grounds that it was rendered in the context of an earlier Act.
(h) As recent as in 2009, the validity of the 1961 Notification, relaxing pre-emptive and other rights from the purview of the SCRA, was upheld by the Punjab & Haryana High Court in the case of M/s. Rama Petrochemicals Ltd. v. Punjab State Industrial Development Corp. Ltd., CWP No. 12861/2006 (Order dated 27th Nov., 2009).
Thus, it is evident that this is a matter which is not free from a judicial controversy. Under the Indian Contract Act, 1872, an offeror makes a proposal to an offeree. Only when such an offer/proposal is accepted by the offeree and there is a valid consideration for the same, an agreement is said to have been executed. An agreement enforceable by law is a contract. Thus, a contract is completed only when there is an offer and an acceptance. In the case of an option agreement, there is only an offer, but no acceptance. Acceptance only takes place when the offeree exercises its option and at that point of time a contract is concluded. Till such time it is a contingent contract. Further, if the option agreement provides that once the option is exercised, it would be executed on a spot-delivery basis, i.e., the payment and delivery would take place either on the same day or by the next day, then the spot-delivery condition would also be complied on exercise of the contract.
Section 2 of the SCRA defines three terms – contract, derivatives and option in securities. Sections 13 and 16 of the SCRA deal with contracts. Section 18A deals with derivatives. Erstwhile section 20 dealt with options. Even section 20 which deals with penalties, provides separate penalties for contracts and derivatives. With the deletion of section 20 even the penalty provision relating to options was deleted from section 23. Thus, there are three separate sections dealing with three different types of instruments. Hence, it is submitted that the 2000 Notification u/s.16 of SCRA applies only to a contract in securities and not to an option in securities. Options in securities is not covered by section 16 and the erstwhile section 20 has been specifically deleted.
Hence, it is submitted that an option agreement is not an executed contract but only a contingent contract and that such an agreement is valid and not hit by the prohibitions under the SCRA.
One can still find some merit in the SEBI’s argument in cases where both the put and call options are at the same price (As was the case in the Vedanta deal). This is because in such cases it is a no-brainer that one of the parties would definitely exercise its option under the Agreement and this could make it the equivalent of a definite/binding forward contract. However, where there is a price differential between the two, then, in the author’s view, an option agreement is valid and enforceable. An option agreement is a contract between two shareholders of a company. How can there be any fetters on the right of a shareholder to sell his shares, to grant an option on these shares, etc.? Can the SEBI’s jurisdiction extend over such private treaties also? Several Government disinvestments, such as, Balco, contained put and call options. Were all of these also be invalid and that too ab initio? One hopes the Regulator takes a relook at these factors and does a rethink on its stance.
Validity of Pre-emptive Rights
Even while we are jostling with the issue of validity of option agreements, comes a much larger issue — are pre -emptive and other rights valid at all in the case of listed and unlisted public companies? These would include pre-emptive rights, such as right of first refusal, tag along rights, drag along rights, etc.
Various Supreme Court decisions, such as V. B. Rangaraj v. V. B. Gopalkrishnan, 73 Comp. Cases 201 (SC), have held that a Shareholders’ Agreement executed between members of a company is binding on the company only if it is contained in the Articles of Association of the company.
A Single Judge of the Bombay High Court in the case of Western Maharashtra Development Corporation v. Bajaj Auto Ltd., (2010) 154 Comp. Cases 593 (Bom.), had ruled that a Shareholders’ Agreement containing restrictive clauses was invalid since the Articles of a public company could not contain clauses restricting the transfer of shares and it was contrary to section 108 of the Companies Act, 1956.
Subsequently, a two-Member Bench of the Bombay High Court, in the case of Messer Holdings Ltd. v. Shyam Ruia and Others, (2010) 159 Comp. Cases 29 (Bom.) has overruled this decision of the Single Judge of the Bombay High Court. The Court here was concerned with the validity of a Right of First Refusal Clause. The Court held that the intent of section 111A of the Companies Act dealing with free transferability of shares does not in any manner hamper the right of its shareholders to enter into private treaties so long as it is in accordance with the Companies Act and the company’s Articles. Had the Act wanted to prevent such private contracts it would have expressly done so. The Court relied on the Supreme Court’s decision in the case of M. S. Madhusoodhanan v. Kerala Kaumudi Pvt. Ltd., (2004) 117 Comp. Cases 19 (SC) which has held that consensual agreements between shareholders relating to their shares do not impose restriction on transferability of shares and they can be enforced like any other agreement.
Hence, as the position now stands, restrictive clauses and pre-emptive rights in a public limited company would be valid under the Companies Act. It may be specifically noted that the judgment in Messer Holdings (supra) was in the case of a listed company which is contrary to SEBI’s stance taken in the case of Cairns as regards validity of pre-emptive rights. The High Court’s judgment is binding even on the SEBI.
A later decision of a Single Judge of the Bombay High Court in the case of Jer Rutton Kavasmanek v. Gharda Chemicals Ltd., (2011) 166 Comp. Cases 377 (Bom.) has held that there are only two types of companies under the Companies Act — private and public. The concept of a deemed public company has been done away with and hence, pre-emptive rights which are contained in the Articles of a public company must not be recognised. Shares of a public company are freely transferrable and this would override anything contained in the Articles to the contrary. It may be noted that the Court did not go into whether a Shareholders’ Agreement executed by members which contained a pre-emptive clause was valid or not. It only dealt with a situation where the Articles of Association contained pre-emptive clauses. The conclusion arrived at seems to be that where the shareholders have not executed any agreement, but the Articles themselves provide for a restriction, the same would be invalid.
Conclusion
One fails to understand when the position has been so well settled since the last several years, why take such steps which upset the investment climate? Even Courts respect the doctrine of stare decisis, i.e., to stand by the decided and not to unsettle the settled law which has been practiced for several years — ALA Firm, 189 ITR 285 (SC). At a time when the international economy is reeling with recession, India is one of the few countries which are looked upon favourably by foreign investors. A monkey wrench in the works would only scare away PE/FDI funds and seriously curtail the Indian growth story. One can only hope that this fog of uncertainty is cleared and sunshine returns soon. The current puzzled regulatory scenario reminds one of William Shakespeare’s famous quote:
“Confusion Now Hath Made his Masterpiece!”
