Clarity On The Enforceability Of Option ContractsBloombergQuintOpinion
The validity of pre-emption clauses, including option clauses, has been questioned for a long time, and arbitral awards for enforcing or invalidating such provisions have been the subject of disputes. The Securities and Exchange Board of India and the Reserve Bank of India have, at many occasions, reflected on the enforceability of some pre-emption clauses but those have been open to interpretation.
Historically, SEBI prohibited certain kinds of contracts falling short of qualifying as ‘spot delivery contracts’ or ‘derivative contracts’ (which were earlier permitted under the Securities Contracts (Regulation) Act, 1956) according to a March 2001 notification. The prohibition primarily stemmed from SEBI considering such pre-emption clauses to be undesirably speculative. For instance, in case of option clauses, the option holder had the right to exercise an option basis a future event. The RBI too deemed such pre-emption clauses more in the nature of debt as opposed to equity, thereby side-stepping the provisions of foreign direct investment policy, which only permitted investments in equities or securities compulsorily convertible into equities.
Thereafter, according to another notification in October 2013, SEBI, rescinding the position it held under its earlier notification, permitted several pre-emption clauses for the purchase and sale of securities in shareholders’ agreements and articles of association of companies, subject to certain conditions. However, it clarified in the same notification that:
- contracts brought under preview of the SCRA would only be valid if they were compliant with the provisions of the extant foreign exchange regulations; and
- the notification would not affect or validate any contracts entered prior to the date of the notification.
In 2014, RBI too, moved from its stricter stance of viewing these contracts in the form of debt , and its circulars on pricing guidelines dated January 9, 2014, and July 15, 2014, allowed option clauses attached to equity shares, compulsorily and mandatorily convertible preference shares and debentures to be issued to non-residents by unlisted companies. However, there would be no guarantee of an assured return or exit price at the time of undertaking the investment.
While SEBI’s 2013 circular settled the validity of options and other pre-emption clauses which came into effect after October 2013, the enforceability of several pre-existing option contracts remained unanswered.
Since then, the judiciary has deliberated on the enforceability of such clauses in several cases. The trend indicates that courts are inclined to safeguard the interests of foreign participants, to protect them against abuse by resident entities who may exploit the law to circumvent their payment obligations. Recently, the Bombay High Court, in an order dated March 27, 2019, set aside an arbitral award which held that a put option provided to Edelweiss Financial Services was void and unenforceable. Edelweiss had purchased shares of Percept Finserve as per a share purchase agreement in December 2007. It had the right to sell the shares to Percept in case of a failure to meet targets or conditions.
The arbitration award viewed the put option as void and unenforceable because it:
- constituted a forward contract,
- contained an option concerning a future purchase of shares, thereby qualifying as a derivative contract not being traded on a recognised stock exchange.
Distinguishing from the arbitral award and relying on a previous order in the case of Multi Commodity Stock Exchange, the Bombay High Court held that a put option is enforceable as the contract of sale comes into existence only after the exercise of such an option, thus upholding the validity of a put option clause which was in effect prior to 2013.
It is to be noted that the options granted to Edelweiss by Percept under the share purchase agreement were executed in 2007 and were exercised in 2008. Both stages happened before the SEBI circular of October 2013 came into effect.
The Bombay High Court held that the put option clause in the agreement was a contract giving an option to Edelweiss to require repurchase of securities by Percept, in the event of an occurrence of a contingency. It observed that on the date when the contract was entered, there was no contract for sale or purchase of shares. The contract for sale or purchase of shares would come into effect, if at all, much later, when the two conditions would be fulfilled, namely:
- failure of conditions subsequent attributable to Percept, and
- exercise by Edelweiss of its option to require repurchase of shares by Percept upon such failure.
It is only after the Edelweiss exercises such option that the contract would be complete, thereby stating that option contracts are not forward contracts.
Further, while deliberating on the legality and validity of such clauses in terms of qualifying them as derivatives (not permitted under Section 18A of the SCRA), the court noted that Section 18A being a non-obstante clause makes contracts referred to in clauses (a) to (c) of section 18A legal and valid.
For such illegality or invalidity, one has to look outside the purview of Section 18A. Similarly, the order clarifies that such pre-existing clauses not being excluded from the 2013 circular, do not make them bad in law or impermissible. The second provision in the 2013 SEBI notification clarified that it does not validate any contract entered prior to the date of notification. That did not, per se, invalidate the pre-existing contracts.
What the law seeks to prohibit is not entering into a call or a put option; what it actually prohibits is trading or dealing in such option, treating it as a security. Only when it is traded in, it attracts the embargo of law as a derivative, that is to say, a security derived from an underlying debt or equity instrument.
Merely because an agreement provides for a put option in respect of securities, such an agreement cannot be termed as a contract in derivatives.
Simply by making a put option concerning a security available, it cannot be termed as illegal and that too under the provisions of Section 18A of SCRA. Therefore, such an option is neither a forward contract nor a derivative contract under Section 2(ac) of the SCRA.
The order has certainly brought some relief in terms of enforceability of pre-emption clauses entered prior to October 2013. While it gives hope, considering the period of limitation has not elapsed for filing a special leave petition, we must wait to see the outcome of further appeal, if any.
For the time being, it is settled that options come into existence when exercised and so long as the delivery of the shares happens simultaneously with the payment remittance it is a spot delivery contract. Also, it is established now that Section 18A of the SCRA only provides positively for legality and validity of contracts in derivative and does not invalidate any contract. To determine its legality, one has to look beyond this provision.
Sanjay Asher is Senior Partner, and Sachita Shetty is Senior Associate, at Crawford Bayley & Co.
The views expressed here are those of the authors and do not necessarily represent the views of BloombergQuint or its editorial team.