The legality of the options for institutional investors in private equity agreements has been subject to an ongoing debate at the hands of various regulatory institutions and investor forums

Option contracts have been an integral part of the private equity transactions in India. Option contracts are used to structure their deals, raise finances from the foreign lenders (especially private equity -PE firms) entering in India and in turn want to secure their interest in the investee company and to this end, pre-emption rights are drafted in the agreements.
 

Another important aspect for a foreign investor is the 'return' which the investing firm will get. In case of unlisted companies, it has been generally seen that PE secures its exit through initial public offering (IPO) or buy-back of shares or purchase of the equity investment of the foreign investor by the promoters. The agreements are so designed that such agreements provide a PUT option to the foreign investor in order to secure the return on its investment.
 

Promoters also have a CALL/PUT option under which, promoters can buy out the shares of the foreign investor at their option. However, the legality of the options in the PE agreements has been subject to an ongoing debate at the hands of various regulatory institutions and investor forums. This article consolidates the regulatory developments on option contracts.
 

Securities Contract Regulation Act, 1956
 

Securities & Exchange Board of India (SEBI) has for long held that options are not a spot delivery contracts but forward contracts.
 

SEBI in its informal guidance note given to Vulcan Engineers Ltd relating to the purchase and sale of shares of the company at a pre agreed price under the PUT/CALL Options stated that:
 

'As [this] (put / call) option would be exercised in a future date...the transaction would not qualify as a spot delivery contract under SCRA S. 2(i), nor as a legal and valid derivative contract in terms of S. 18A.'
 

Similarly, in the Cairn-Vedanta transaction SEBI was of the view that put option and call option arrangements and the Right of First Refusal do not conform to the requirements of a spot delivery contract nor with that of a contract of Derivatives as provided under section 18A of the Securities Contracts (Regulation) Act, 1956 (SCRA). Also, put option and call option arrangement along with the right of first refusal are in violation of Notification No. SO 184(E) dated March 1, 2000 issued by SEBI.
 

Bombay High Court in the case of Niskalp Investments & Trading vs Hinduja TMT Ltd (2008) 143 CompCas 2004 (BOM), held 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."
 

On the contrary, Bombay High Court in the case of MCX Stock Exchange Ltd vs Securities & Exchange Board of India & Ors 2012 (114) BomLR 1002 held as follows:
 

"In the case of an option, a concluded contract for purchase or repurchase arises only 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 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."
 

Thus, according to the Bombay High Court, once a contract is arrived at upon the option being exercised, the contract would be fulfilled by spot delivery and would, therefore, not be unlawful. However, the Supreme Court held on SEBI’s appeal that it is needless to say, in making amendments in the Regulation, SEBI shall not be bound by any observations or comments made by the High Court in the impugned judgment.
 

Amendments by SEBI
 

By way of the notification, SEBI has enhanced the scope of contracts that are valid under the SCRA. The following have now been included within the scope of permissible contracts under SCRA:

1. Contracts for pre-emption including right of first refusal, or tag-along or drag along rights contained in shareholders agreements or articles of association of companies or other body corporate;
    
2. Contracts in shareholders agreements or articles of association of companies or other body corporate, for purchase or sale of securities pursuant to exercise of an option contained therein to buy or sell the securities.

The contract for the purchase or sale of securities pursuant to the exercise of an option under clause (d) is subject to certain conditions:
 

• • The title and ownership of the underlying securities is held continuously by the selling party to such contract for a minimum period of one year from the date of entering into the contract;
   
• • The price or consideration payable for the sale or purchase of the underlying securities pursuant to exercise of any option contained therein, is in compliance with all the laws for the time being in force as applicable;
   
• • The contract is settled by way of actual delivery of the underlying securities.
   

In addition, the notification clarifies the following:
 

• The contracts now included within the scope of the SCRA shall be in accordance with the extant exchange control laws of India;
   
• The changes shall not affect or validate any contract which was entered into prior to the date of the Notification.
   

By including options contracts, SEBI has clarified a long standing debate.

RBI’s regulation and amendments
 

Though SEBI has permitted options in shareholders' agreements, options contracts have been subjected to the extant exchange control regulations. Reserve Bank of India (RBI) has held that these contracts which offer a guaranteed or assured return to the investor are more in the nature of debt as opposed to equity, and hence the same should be covered under European Central Bank (ECB) norms. Assured returns would allow a private equity investor to floor a minimum return from his investment and eliminate his risk of business exposure to which other equity investors are exposed. This makes option contracts appear like debt. In the past, the RBI has even issued various show cause notices for removal of such provisions.
 

However, the position of the RBI has changed as the central bank prescribed a new pricing regime applicable to foreign investor exits using call & put options. The RBI has made it clear that all existing foreign investment contracts that promised exit options with assured returns to foreign investors need to be reworked to qualify as foreign direct investment (FDI) compliant. The RBI has specifically disallowed assured returns.
 

Under the new norms, there are two separate regimes: one for agreements with optionality clauses and one without optionality clauses. A non-resident dealing with listed equity shall buy at not less than preferential allotment price and sell at not more than preferential allotment price. In case of selling with the use of option, the non-resident shall sell at market price. A non-resident dealing with unlisted equity shall buy at not less than discounted cash flow (DCF)-based price and sell at not more than DCF-based price. In case of selling with the use of option, the non-resident should sell at not more than return on equity (RoE)-based price. In case of equity shares of unlisted company, the exit price for a foreign investor exiting via option shall not exceed that arrived on the basis of RoE as per latest audited balance sheet.
 

One reason from shifting from DCF to RoE might be the fact that in DCF, projected cash flows as well as the discounting factor can be adjusted easily, whereas the RoE is based on actual performance and is a reflector of past performance. The other reason is probably the fact that if the RBI is to view optionality clauses as equity investments and not debt investments, then private equity investors, like other equity investors, should be exposed to the downside risks of the business, which is adequately captured in the RoE.
 

The use of RoE is simpler and to the advantage of private equity investors. Let us take an example. Say an investor invested Rs1,000 in 100 shares of Rs10 each. If the RoE in the specified year is 5% and the investor held the investment for three years, then the investment is now worth Rs1,000 X (1+0.05)^3 which is equal to Rs1,157.625. Therefore, the price of each share will be worth a maximum of Rs115.7625
 

If in the previous example, the option contract said that the investor would demand 3x the RoE, then the rate of return would be 3 X 5% which is equal to 15%. Then the investment after 3 years would be worth Rs1,000 X (1+ 0.15)^3 or Rs1,520.875, and the share price will be worth a maximum of Rs152.0875.
 

Let’s give a non-example. Investor A invests Rs100 in a company for 5 years. The company generates Rs30 per year and this leads to a net worth of Rs250. If in the sixth year, the company generates Rs25, then the RoE is 25/250 X 100=10%. Then the Investor A, according to some in the legal fraternity, will receive Rs100 + 10% which is Rs110. The flaw in this approach is failing to capitalise the RoE. If we go by this approach, then had the investor invested his money for one year only, instead of five years, his return would have been the same Rs100 + 10% which is Rs110. This is impractical. The investor may put his money up in a high-interest yielding account or a fixed deposit, instead of putting in a company, and get higher assured returns.
 

Lawyers have to be clear on this. The RBI regulation says any price that is arrived on the basis of the RoE is valid. A higher price than that arrived on the basis of RoE is not valid, but a lower price is valid. The RoE some years down the line is not known to the investor in advance, so it is not an assured return. It is the variable in the equation for calculating return on his investment. This means that a private equity investor investing for a long term will have higher returns than an investor investing for short term, depending on the improvements in the performance of the company which is reflected in its RoE. But if the performance of the company is bad, then the investor may have to take a hit or not exercise the option and continue for a longer term or think of other methods to exit. This is should be a welcome move for investors.
 

Companies Act, 2013
 

Finally we come to Companies Act, 2013. The Companies Act, 1956 did not have any section on CALL/PUT OPTIONS or FORWARD and FUTURE contracts. This used to be regulated by SCRA.

Section 58(2) of Companies Act, 2013 says:

....the securities or other interest of any member in a public company shall be freely transferable, provided that any contract or arrangement between two or more persons in respect of transfer of securities shall be enforceable as a contract.

This validates and enforces contracts entered into between promoters and private equity investors. The Act also does not put any restrictions on the price of such contracts.

Further, Section 194 of Companies Act 2013 is a new development aimed to assist institutional investors like private equity firms to exit from the company. The Section says:

No director of a company or any of its key managerial personnel shall buy in

the company, or in its holding, subsidiary or associate company—

(a) a right to call for delivery or a right to make delivery at a specified price and

within a specified time, of a specified number of relevant shares or a specified amount of relevant debentures; or

(b) a right, as he may elect, to call for delivery or to make delivery at a specified

 price and within a specified time, of a specified number of relevant shares or a specified amount of relevant debentures.

While the language of the Section appears prohibitive at first glance, a careful analysis will show why this Section is a welcome move for institutional investors. Although the Section mandates a director (who is a promoter) or key managerial personnel (KMP) cannot hold a right under this Section, it does not prohibit the director from becoming a writer of a call or a put option. Accordingly, such director o KMP can take up an obligation to buy a specified number of shares at a later date. The party intending to sell the shares at the later date will be the private equity fund which may appoint a nominee director on the Board of the company. The nominee director does not buy the right in his own name but in the name of the fund, which is not prohibited. The nominee director is not paying the consideration for the contract, but the private equity firm which is paying consideration. This will avoid any remaining confusion and undue fears.

(Shambo Dey , is a student at the Government Law College, Mumbai and also works as a researcher for Vinod Kothari & Company)