Introduction
A Share Purchase Agreement is a contract that lays out the terms and conditions related to the sale and purchase of shares in a company, ensuring that both parties are in an agreement. This agreement covers important details such as shareholder rights, responsibilities, and other key terms, making it crucial for maintaining coherence between the buyer and seller. Without this agreement, it would be challenging to protect the interests of both parties involved.
In a Shareholder’s Agreement, an option clause is a provision that specifies the rights and obligations of shareholders. This clause gives investors the choice to either ‘call’ or ‘put’ the equities on the table, which requires the founders to buy or sell the equities at a predetermined price.
A put option allows investor shareholders to exit the company. When the put option is exercised, the party being exercised upon is obligated to purchase the shares at a predetermined price. For example, if Shareholder 1 wants to exit the company after five years unless it meets certain revenue targets, a put option clause in the shareholders’ agreement would give them the right to require the company to repurchase their shares at a predetermined price.
Modification of Put Option Clause
In 1969, a notification was issued under the Securities and Contract Regulation Act (SCRA) which made all contracts related to buying or selling securities, except for spot delivery contracts or contracts settled through the stock exchange, illegal and void. The 1969 Notification was repealed in 2000, but the Securities and Exchange Board of India (SEBI) issued a notification on March 1, 2000 (SEBI 2000 Notification) which had provisions similar to the 1969 Notification. As a result, the effect of the repeal of the 1969 Notification was nullified. SEBI issued informal guidance in 2011, reiterating that call or put options did not fall under the category of spot delivery contracts and hence were not valid in the eyes of the law. Therefore, SEBI considered options to be either forward contracts or derivatives under the SCRA, and thus not enforceable.
SEBI released a notification on October 3, 2013 (SEBI 2013 Notification) which revoked the SEBI 2000 Notification and broadened the scope of permissible contracts under the Securities and Contract Regulation Act (SCRA) to include option contracts. The SEBI 2013 Notification stated that option contracts could be included in shareholder agreements and in the articles of association of companies/body corporates for the buying or selling of securities, provided that the following conditions were met:
a. the title and ownership of the underlying securities should be held continuously by the selling party for a minimum period of 1 (one) year from the date of entering into the contract;
b. the price or consideration payable for the sale or purchase of the underlying securities pursuant to exercise of any option contained therein should be in compliance with all the laws for the time being in force as applicable; and
c. the contract should be settled by way of actual delivery of the underlying securities. Moreover, these contracts must comply with the provisions of the Foreign Exchange and Management Act, 1999 (“FEMA”) and its corresponding rules and regulations.
According to the SEBI 2013 Notification, it was explicitly mentioned that it would not have a retrospective effect. The notification clarified that it would not impact or legalize any contracts that were made before the date of the notification.
CASE: Edelweiss Financial Services Ltd. v. Percept Finserve Pvt. Ltd.
In this case, the Bombay High Court upheld the validity of the MCX Stock Exchange judgement. The court ruled that put option clauses in contracts made before 2013 were not considered ‘forward contracts’ under the SCRA because option contracts are performed on a spot delivery basis. The court also stated that allowing the promoter time to repurchase shares after exercising the put option did not automatically classify it as a forward contract. The key factor was that there was no indication of any delay between payment and delivery of shares. It held that a put option clause contained in share purchase agreements is legally valid under the provisions of the Securities Contracts (Regulation) Act, 1956 (‘SCRA’).
Dispute background
Edelweiss Financial Services Limited purchased shares worth 20 crore rupees of Percept Limited from Percept Finserve Private Limited in December 2007, according to a share purchase agreement (SPA). The SPA contained a Put Option Clause stating that if Promoter / Percept violated specific terms, Edelweiss could either sell the shares back to the Promoter at a price that would provide Edelweiss with a 10% internal rate of return or continue to hold the shares subject to certain Promoter undertakings. Edelweiss claims that the Promoter and Percept did not meet some obligations under the SPA and has decided to exercise the Put Option, which required the Promoter to buy back the shares. However, the Promoter refused to comply, leading to arbitration being initiated, and a sole arbitrator was appointed to settle the disputes between the parties.
After finding that the Promoter and Percept had breached their obligations under the SPA, the arbitrator denied Edelweiss’s Put Option claim, citing its illegality on two main grounds:
The Put Option was deemed a forward contract, which is expressly forbidden by Section 16 of the Securities Contract Regulation Act (SCRA) and SEBI’s circular dated March 1, 2000; and
b. The Put Option was considered a derivative contract, and since it was not traded on a recognized stock exchange, it contravened Section 18-A of the SCRA, making it illegal.
Key Arguments
Edelweiss Arguments
Edelweiss contested the arbitrator’s decision on the grounds that it conflicted with the verdict of the Bombay High Court in the case of MCX Stock Exchange Ltd v. SEBI, also known as the “MCX Judgment.” According to the MCX Judgment, put option contracts cannot be classified as forward contracts because the contract is created on the day when the option is exercised, and then it can be executed as a spot delivery contract. Thus, Edelweiss disputed the legality of the arbitrator’s ruling that the Put Option was illegal because it constituted a forward contract.
Furthermore, Edelweiss argued that the Put Option did not qualify as a derivative contract as defined under Section 18-A of the Securities Contract Regulation Act (SCRA). According to Edelweiss, the Put Option was not a type of derivative since it did not derive its value from an underlying security or asset. Moreover, since the Put Option was an agreement between two private parties and was not traded on a recognized stock exchange, it could not be considered a derivative contract, as stated in Section 18-A of the SCRA.
In light of these arguments, Edelweiss sought to challenge the arbitrator’s decision, contending that the Put Option was neither a forward contract nor a derivative contract and therefore not illegal.
Promoter / Percept Arguments
The Promoter presented a counterargument, claiming that the present case differed from the MCX Judgment. In this case, Edelweiss had exercised its Put Option and requested the Promoter to purchase the shares within a specific timeframe, rather than immediately. Therefore, the purchase of shares was postponed even after the Put Option had been exercised, which according to the Promoter constituted a forward contract, thus making it illegal. The Promoter further argued that the Put Option was a type of derivative, as it granted the option to repurchase shares in the future. Therefore, if the Put Option was not managed in accordance with Section 18-A of SCRA, it would be considered illegal.
Moreover, the Promoter contended that a SEBI circular dated October 3, 2013 (“SEBI 2013 Circular”) provided an exemption for option contracts that were included in shareholders’ agreements. However, the SEBI 2013 Circular expressly stated that it did not validate any contracts prior to its date. As a result, the Promoter argued that entering into such option contracts prior to 2013 was unquestionably illegal under the law.
Judgement
A judge sitting alone in the Bombay High Court overturned the decision made by an arbitrator under Section 34 of the Arbitration and Conciliation Act, 1996. The court ruled that the case was similar to the MCX Judgment, which stated that a put option could not be regarded as a forward contract since it was conducted on a spot delivery basis, where shares and payment were exchanged at the same time or within one day of the contract’s creation.
The put option only comes into force if two requirements are satisfied: the promoter’s failure to restructure within the specified period and the exercise of Edelweiss’ option to require repurchase by the promoter in such a situation. The court also stated that the put option could not be regarded as a forward contract solely because the promoter was given some time to repurchase after the put option was exercised, and there was no indication that there was a time delay between payment and share delivery or which came first. The court examined the put option in the context of Section 18-A of the SCRA. The section stated that “contracts in derivatives” would be legal and binding if they were (a) traded on a recognized stock exchange, (b) settled on the clearing house of a recognized stock exchange, or (c) between such parties and on such terms as the central government may specify in accordance with the rules and bye-laws of such stock exchange. The court held that Section 18-A did not explicitly prohibit the creation of a call or put option, but instead regulated trading or dealing in such options as securities.
Regarding the SEBI 2013 Circular, the court clarified that it was not a protective notice, but a prohibitory one that prohibited all contracts except those mentioned therein. Furthermore, the court ruled that if a contract was simply an options contract, it was never prohibited in the first place and thus could not be saved by the SEBI 2013 Circular. The court ruled that the arbitrator had erred on these fundamental issues by treating the contract as a “contract in derivative” solely because it contained a put option for securities. Consequently, the court overturned the arbitral award on the grounds of illegality.
Conclusion
Despite being in force for several years, the controversy surrounding spot delivery contracts has yet to be resolved. However, recent amendments introduced by Indian regulators since 2013 have brought some relief to both domestic and foreign investors. It is crucial to draft investment agreements and shareholders agreements that include put options with care, ensuring compliance with all applicable laws. To draft a put option clause in the safest possible way, the following principles should be considered: if all parties are residents, the put option clause should ensure that it is a spot delivery contract when performance takes place. If the option holder is a non-resident, the sale price should not exceed the fair market value, and a one-year lock-in period should be provided for in the contract.
The current definition of a spot delivery contract requires the actual delivery of securities and payment of the price to take place within one day from the date of the contract. This creates a problem as the delivery of shares and payment are usually not completed on the date of the contract or within one day of it. However, the recent court ruling suggests that simultaneous delivery of shares and payment of price would be considered a spot delivery contract. This ruling is praiseworthy, as it gives hope that these issues will finally be resolved, albeit belatedly.
References
1. https://www.azbpartners.com/bank/enforceability-of-put-option-under-scra-upheld-by-bombay-high-court/#:~:text=Ltd.,thereunder%20(‘Judgment’).
2. https://www.mondaq.com/india/fund-management-reits/860054/put-options—enforcement-and-claiming-damages–indemnity
3. https://corporate.cyrilamarchandblogs.com/2023/03/enforceability-of-put-options-under-scra-bombay-hcs-latest-judgment-finally-clears-the-air/
4. https://www.snrlaw.in/enforcement-of-foreign-awards-granting-a-put-option-despite-objections-under-the-fema/
5. http://nishithdesai.com/generateHTML/4518/4
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Author details: Purvi Raheja, BBA LLB. , 4th Year, Vivekanand Institute of Professional Studies
