Shareholder groups of listed companies and even public companies often face a nagging problem. Many of them enter into agreements giving rights to each other of different kinds over the shares held by them. These may be in the form of restrictive or pre-emptive rights or rights to purchase the shares under certain terms and conditions. The concern that keeps bothering them is whether such rights and terms are valid under law or void or, even worse, whether these are illegal.
A recent decision of the Bombay High Court (MCX Stock Exchange Limited v. SEBI and Others, WP No. 213 of 2011, dated March 14, 2012) partially sets at rest — at least to the extent a High Court decision can — the concern whether an agreement giving certain options to purchase/sell shares is void and illegal being agreements for futures under the provisions of the Securities Contracts (Regulation) Act, 1956 (SCRA). This should help shareholders and investors of various hues who have entered into such contracts with other shareholders and faced the possibility that they may be held illegal/ void. As will be seen later though, a related issue has been kept open and so the question is not yet fully answered. Also, needless to emphasise, the decision is on facts of the case and one would have to see whether the agreements and surrounding circumstances in each case are such that the ratio of the decision may apply.
To elaborate the issue further, before we go into the facts of the case, the SCRA, to simplify a little, was enacted mainly to regulate stock exchanges and trading on it. For this purpose, it was desired that trading in securities should take place only in regulated stock exchanges. Options, futures, etc. being securities were also required to be traded on stock exchanges. To ensure that parties do not carry out private transactions in such securities including by way of options and futures, such private transactions, subject to specified exceptions, were declared illegal and void. Stock exchanges provide a transparent mechanism for carrying out such transactions in securities also giving safety to counter parties and at the same time, other objectives such as control of undue speculation could be achieved. Hence, transactions through such exchanges were intended to be encouraged.
However, the manner in which the relevant provisions were worded resulted even in a very common set of private agreements being put to question. For example, major shareholders — particularly strategic investors — often enter into agreements whereby one or both are given an option to buy or sell the shares under certain circumstances. Such agreements are rarely assignable to third parties, are not standardised and have unique terms and conditions attached, are not generally severable into small units, etc. In other words, they do not resemble the typical options or futures that are traded on stock markets. However, the conservative view — and often endorsed by SEBI — was that such agreements amount to options/futures and hence may be held to be void and illegal.
The other provision that such private agreements fell foul of was the provisions relating to free transferability of shares. While the essence of private limited companies was restricted transferability of shares, public companies (including listed companies) required free transferability of shares. This, inter alia, enabled buyers of shares being freely able to buy shares — on and off the stock exchanges — without worrying about any restrictions the transferor may be facing. It also ensured that even the company was bound to register the transfer of the shares. Such private agreements providing for options, in a sense, created a restriction on the transfer of the shares. The question once again was whether such agreements fell foul of the law providing for free transferability of shares.
Arguably, the regulator and the law-makers had other reasons too to restrict agreements. These reasons went beyond the above purposes of ensuring trading in securities took place on stock exchanges only or to ensure that there is free transferability of shares for benefit of parties. Restrictions helped achieve other objectives such as limits on foreign holding, avoidance of benami holding of shares, etc. The problem was these provisions of SCRA which had other objectives to serve were also used and applied for such purposes. Thus, instead of making specific provisions to deal with specific concerns, they used the widely framed provisions of the SCRA. This thus resulted in bona fide and fairly common private agreements being subjected to the risk of being held illegal and void.
Coming to the Bombay High Court decision, a Company was formed by a Promoter Group for enabling trading in securities, etc. and thus required registration with the Securities and Exchange Board of India. Since a recognised stock exchange serves certain public purposes and it is not in the pubic interest that the ownership of such stock exchange is concentrated, the law provides that a group of persons acting in concert should not hold more than 5% of the share capital of such company. The relevant Regulations are in fair detail and various issues concerning it were the subject-matter of the Court decision. However, since the focus here is on the issue of validity of certain agreements relating to shares between shareholder groups, the other matters dealt with by the Court are not considered here.
It appears that the Promoter Group originally held significantly more than 5% of the share capital of the Company. To ensure that it is in compliance with the law, a complex restructuring scheme was carried out. To simplify the matter to help focus on the issue of law, the restructuring can be explained as follows. The share capital of the Company was reduced under a court-approved scheme and further shares were issued to persons other than the Promoter Group. Further, certain shares held by the Promoter Group were transferred to other parties. The Promoter Group had entered into an agreement with certain parties holding shares in the Company whereby certain shareholders had an option to sell their shares to the Promoter Group under certain terms and conditions.
The issue was whether such an agreement amounted to options/futures and thus illegal and void. The Court analysed the nature and essence of the agreements and also the law on the subject matter. Firstly, it held that the agreements did not amount to contract of futures. Contract of futures necessarily involved agreements where the agreement to purchase/sale was concluded but only the payment and delivery was postponed. In the present case, since there was an option to sell, there was no current concluded transaction of purchase/sale. In fact, the transaction of purchase/ sale may not even arise in the future if the party did not exercise its option. Thus, the Court held there was no agreement of futures. The Court, however, did not deal with the issue whether the agreement amounted to an option, because this was not part of the allegations under the Notice issued to the aggrieved party. The Court asked SEBI, if it desired to raise that issue, to give an opportunity to the aggrieved party first.
Let us consider some extracts from the decision of the Court to consider the matter in context.
The Court described the nature of the agreements between FTIL (the Promoter) and PNB/ILFS (the counter parties) in the following words:
“The buy -back agreements furnish to PNB and IL&FS an option. The option constitutes a privilege, the exercise of which depends upon their unilateral volition. In the case of PNB, the buy-back agreements contemplated a buy-back by FTIL after the expiry of a stipulated period. But, in the event that PNB still asserted that it would continue to hold the shares, despite the buy-back offer, FTIL or its nominees would have no liability for buying back the shares in future. In the case of IL&FS, La -Fin assumed an obligation to offer to purchase either through itself or its nominee the shares which were sold to IL&FS after the expiry of a stipulated period. In both cases, the option to sell rested in the unilateral decision of PNB and IL&FS, as the case may be.”
Does the agreement amount to a contract of future so as to be violative of the law and hence illegal and void? The Court further analysed and observed as follows:
“In a buy-back agreement of the nature involved in the present case, the promisor who makes an offer to buy back shares cannot compel the exercise of the option by the promisee to sell the shares at a future point in time. If the promisee declines to exercise the option, the promissor cannot compel performance. A concluded contract for the sale and purchase of shares comes into existence only when the promisee upon whom an option is conferred, exercises the option to sell the shares. Hence, an option to purchase or repurchase is regarded as being in the nature of a privilege.
…
77. The distinction between an option to purchase or (repurchase and an agreement for sale and purchase simpliciter lies in the fact that the former is by its nature dependent on the discretion of the person who is granted the option, whereas the latter is a reciprocal arrangement imposing obligations and benefits on the promisor and the promisee. The performance of an option cannot be compelled by the person who has granted the option. Contrariwise in the case of an agreement, performance can be elicited at the behest of either of the parties. In the case of an option, a concluded contract for purchase or repurchase arises only if the option is exercised and upon the exercise of the option. Under the notification that has been issued under the SCRA, a contract for the sale or purchase of securities has to be a spot delivery contract or a contract for cash or hand delivery or special delivery. In the present case, the contract for sale or purchase of the securities would fructify only upon the exercise of the option by PNB or, as the case may be, IL&FS in future. If the option were not to be exercised by them, no contract for sale or purchase of securities would come into existence. Moreover, if the option were to be exercised, there is nothing to indicate that the performance of the contract would be by anything other than by a spot delivery, cash or special delivery. Where securities are dealt with by a depository, the transfer of securities by a depository from the account of a beneficial owner to another beneficial owner is within the ambit of spot delivery.”
Finally, it concluded, with the following words, that the agreement was not in the nature of a futures contract:
“80. In the present case, there is no contract for the sale and purchase of shares. A contract for the purchase or sale of the shares would come into being only at a future point of time in the eventuality of the party which is granted an option exercising the option in future. Once such an option is exercised, the contract would be completed only by means of spot delivery or by a mode which is considered lawful. Hence, the basis and foundation of the order which is that there was a forward contract which is unlawful at its inception is lacking in substance.”
The next issue whether the agreements “would amount to an option in securities and, therefore, derivatives which were neither traded nor settled at any recognised stock exchange, nor with the permission of Securities and Exchange Board of India and therefore in violation of SCRA”. The Court noted that this allegation did not form part of the original notice and thus parties were not given an opportunity to reply to SEBI. Thus, SEBI was required to first give such an opportunity and then give its decision and then the question of appeal may arise.
The decision gives relief to parties who have entered into or propose to enter into such agreement at least from the concern that such agreement may amount to a futures agreement. Needless to emphasise, the decision was on facts. The other concern, though, remains open and that is whether such an agreement may amount to an option which is prohibited under law. It will have to be seen what course of action SEBI takes and whether the matter goes back to the Court.
However, it is time that the law-makers and even SEBI take the initiative and resolve the controversy. It does not seem that there can be any objection to such private agreements between two groups of shareholders where most of the elements of standardised over the counter futures/options contracts are absent. Such private agreements should be explicitly exempted and if desired, the specific areas where the law-makers have concern can be duly regulated.
