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Legal validity of put options

The validity of put options with reference to the FDI Policy has not specifically considered by courts, but they are a standard feature in investment agreements by foreigners. However, the wording of the put option clause differs in each investment agreement. Corporate lawyers are also known to structure the option in a crafty way so that it is not in violation of law.
Currently, put options are valid if the following requirements are met:
  • A minimum lock-in on the foreigner’s shareholding of 1 year is necessary. If under a certain sector a higher lock-in is prescribed under FDI regulations, then a higher lock-in will be applicable. For example, under construction development sector, a lock-in of 3 years has been prescribed under the FDI policy, which will apply to a foreign investor who has invested in this sector, before he can exercise his option.
  • No assured return or exit price can be guaranteed to the investor.  
  • The new pricing guidelines of the Reserve Bank of India, as released in January 2014, must be complied with, which are as follows: .
  • The price of equity shares must be capped on the basis of a specific method known as the return on equity method (which calculates the ratio of profits after tax to the total net-worth).
  • The price of any convertible instruments (such as compulsorily convertible preference shares or compulsorily convertible debentures) must be arrived at in accordance with any internationally accepted pricing methodology (for example - return on equity, discounted cash flow, book value are some of the internationally accepted pricing methods). A SEBI registered Category I Merchant Banker or a Chartered Accountant is responsible for providing a certificate for arriving at the price.
  • Listed securities on which options are exercise will be transferred on the market price.
See the SEBI notification and RBI circular for more details.
The regulatory environment around put options has been in a state of flux. Although put options are currently valid (subject to certain conditions), it is useful to refer to the reasons why they frequently require to be tested against the law. The following discussion captures the legal issues that have surrounded put options in recent times:
  1. Put options on shares of public companies impose restrictions on the transferability of their shares, by restricting the freedom of the shareholder to sell the share to the person who exercises the option, and to nobody else. This was believed to be against the provisions of the Companies Act - under Section 111A of the Companies Act, 1956 shares of a company are freely transferable and restrictions on their transferability cannot be imposed (even in a private contract between shareholders). However, the Companies Act 2013 contains specifically permits enforcement of contracts for transfer of securities privately amongst shareholders .
  2. Put options on shares of public companies are violative of the Securities Contracts Regulation Act (SCRA). Until recently, options were considered to be derivative contracts, which, as per the SCRA, which are valid only if they are listed on a stock exchange. Second, as per a Central Government notification issued pursuant to the SCRA, only specific contracts where the transfer of shares occurs almost simultaneously (or within a very short time) with the agreement coming into legal effect, and which are executed within the framework prescribed by a stock exchange are valid. These contracts are known as spot delivery contracts or contracts for cash or hand delivery or special delivery. In the case of put options granted to investors, however, the right to purchase is exercised much after the options agreement (or clause) is legally effective – hence, it is understood to be illegal as it does not meet the above requirements.
The only exception to this was if the options are themselves listed and traded on the exchange – which was never the case for venture capital or private equity investments.
  1. Put options granted to foreigners could violate the Foreign Exchange Management Act (FEMA) - The Foreign Direct Investment Policy circular of the Central Government issued in 2011 had initially contained a clause stating that in-built options in investment transactions are not permitted (which appeared to include put options, as per the view taken by legal experts). However, the clause was later withdrawn through a corrigendum issued by the government – which came as a relief to corporate lawyers.
However, certain put options purport to promise a guaranteed rate of return – e.g. a minimum internal rate of return of 25 percent. It is possible for such options to be considered as similar to debt – in that case, they will constitute external commercial borrowings (ECBs) and will have to comply with the provision of ECB Regulations. ECB Regulations are relatively restrictive and it many investment transactions may be in violation of them if ECB Regulations are attracted.
Those who are interested in further reading can go read the following:
  • MCX Stock Exchange Limited v. Securities & Exchange Board of India & Ors. 2012 (114)  BomLR 1002
  • Naresh K. Agarwalla v. Canbank Financial Services Ltd. (2010) 6 SCC 178
  • SEBI’s letter to Cairn India, available here, last visited on 3 October 2011.
  • SEBI’s informal guidance to Vulcan Engineers, CFD/DCR/16403/2011.
  • Nishkalp Investments & Trading v. Hinduja TMT Ltd. (2008) 143 CompCas 2004 (BOM)
  • Bhagwati Developers v. Peerless General Finance and Investment Company Limited,  available here
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