RESTING IN PEACE: THE CONUNDRUM OF ENFORCEABILITY OF PUT OPTIONS IN THE INDIAN SECURITIES MARKET
Author: Devanshi Shukla, IV year of B.A. LL.B. (Hons.) from Maharashtra National Law University Aurangabad
Warren Buffet has described derivatives as being “financial weapons of mass destruction”. In the Indian securities market, derivatives such as options have had a litigious history. Though for a significant period of time validity and enforceability of options was clouded with uncertainty but the issue had been laid to rest via the notifications and judgments of SEBI and the Courts respectively. The recent Bombay High Court judgment in the case of Percept Finserve Private Limited v. Edelweiss Financial Services Limited provided further clarity with regards to the applicability of the SEBI Notification of 2013 to options executed prior to the notification. In this blog, we will look into the rationale behind the validity of put options.
KEYWORDS: option, derivatives, enforceability, derivatives, securities.
“The most important single central fact about a free market is that no exchange takes place unless both parties benefit.”[i]
With India being primed as one of the most profitable markets for investors,[ii] an investor-inclined rhetoric has gained momentum and has made companies incorporate exit options in various agreements in order to prioritise investor interest.[iii] Option clauses are exit rights invoked at vital stages by the investors which guarantee them a stress free exit with assured returns.[iv] Options are of two kinds, call options and put options. In this blog, we are only concerned with put options. Put options are exit rights granted to an investor to sell shares to other shareholders or any third party at some point in the future. The enforceability of put options had been a point of contention in the Indian securities jurisprudence for decades.
The origin of the issue of enforceability of put options can be traced back to the erstwhile § 20 of SCRA (Securities Contracts Regulation Act, 1956) which made options in securities illegal. Subsequently, a Notification of the Central Government in 1969 clarified that all contracts for the sale or purchase of securities other than other than as provided were to be illegal.[v] § 20 was removed from SCRA by the 1995 Amendment[vi] but the 1969 Notification continued to be in force. Later on in 1999, § 18A was inserted in SCRA which provided that all contracts in derivatives were valid and legal, subject to certain conditions.[vii] The legislative intent behind the introduction of § 18A was to provide safety to cash settled derivatives (which include options) from any contentions regarding it being a wager.[viii] The Amendment highlights the intent towards securing the market for investors.[ix] The 1969 Notification was replaced by the Notification released in March 2000.[x] However, the change in discourse came with the October 2013 Notification issued by SEBI which permitted put options subject to the certain conditions.[xi]
THE LEGAL ENFORCEABILITY OF PUT OPTIONS
Options are contingency contracts, i.e., conditional contracts that can only be exercised on the non-performance or performance of certain conditions. Options though valid have time and again remained in question due to various judicial pronouncements. The rationale behind this is that only certain prescribed forms of transactions concerning securities are permissible in order to “avoid unwanted speculation in the specified securities”. SEBI has often issued directives to companies to remove put options or pre-emptive rights clauses from their deal agreements.[xii]
OPTIONS ARE NOT FORWARD CONTRACTS
An option in securities has been deemed to be a privilege or a concession.[xiii] But it has to be understood that the exercise of the option depends upon the discretion of the person who has been granted the option. It is on him/her to exercise or not to exercise the option. Such an exercise cannot be forced by the other party.[xiv] No contract would come into existence if the party having the option never exercises it.
The High Court of Bombay in relation to the Bombay Securities Contracts Control Act, 1925 (which was the predecessor of the SCRA) has elaborated on the conspicuous distinction between “the situation where there is a present obligation under a contract and its performance is postponed to a future date and the scenario where there is an absence of any present obligation but the performance only arises because of some contingency.”[xv] The second category of contracts was deemed to be valid and enforceable.[xvi] Option contracts satisfy the second criteria. The performance and the existence of a contract would only come into being when there has been an exercise of the option at the behest of a party.
This approach was however negated in the case of Nishkalp Investments and Trading Company Limited v. Hinduja TMT Limited.[xvii] Here, the Court did agree with the proposition that contingent contracts were legal and came within the purview of the SCRA but it was also clarified that a ready delivery contract as under the Bombay Securities Contracts Control Act, 1925 was distinct from a spot delivery contract as under SCRA and thus, the interpretation as devised in the Jethalal C. Thakkar judgment[xviii] would not be applicable to it.
Spot delivery contracts have remained in the grey area for most of the 60 years since the SCRA was passed. Under spot delivery contracts, the delivery of securities and their payment occurs on the same day or the subsequent day.[xix] The High Court further held that an agreement for buy-back of shares was not legally valid as it did not fall under spot delivery contracts and was deemed to be unenforceable in law.[xx] Options were thus, construed to be forward contracts. Forward contracts exist between two parties when one of them agrees to buy a financial asset sometime in the future at a stipulated price while the other party agrees to deliver the same asset at the pre-stipulated price.[xxi] Forward contracts are alleged to be speculative in nature as there is no actual delivery of securities and therefore, unenforceable.
This proposition was rightly overturned by the landmark ruling of MCX Stock Exchange v. SEBI & Ors.[xxii] (MCX Judgment) which categorically established that option contracts are distinct from forward contracts. Forward contracts are not settled on the stock exchange as they are worked out directly between two parties[xxiii] and thus, have been prohibited under § 16 of the SCRA. Even though an option contract is not settled on the stock exchange still it would only come to exist if the party possessing the option exercises it. Once the contract comes into existence after the exercise of the option, it would be fulfilled by spot delivery and thus, would not be unlawful.[xxiv] Therefore, an option would be outside the ambit of § 16 and not qualify as a forward contract.
The case which arose in relation to the share purchase agreement entered into between Edelweiss Financial Services Limited and Percept Finserve Private Limited under which Edelweiss purchased shares of Percept Limited provided further clarity on the same.[xxv] This agreement was subject to certain conditions which Percept had been unsuccessful in fulfilling and thus, was in breach of the agreement. As a result of the breach, Edelweiss was entitled to resale of the shares to Percept. Percept failed to fulfill its obligations. Edelweiss had the option to either exit or continue as a shareholder of the Percept group. The Court identified that the issue as to the validity of the option clearly fell within the scope of the MCX Judgment. The put option could not be qualified as a forward contract just because the party having the exercise of the option was provided with sometime to repurchase, after the option is exercised. There is no evidence to the claim that there is any time difference between the payment and delivery of shares or whether the shares would be delivered prior to the payment or vice versa.
OPTIONS ARE NOT INVALID DERIVATIVE CONTRACTS
§ 18A of the SCRA provides for “contracts in derivatives” and states that they would only be “legal and valid if they are traded on the floor of the stock exchange or settled on the clearing house of a recognised stock exchange according to the bye-laws and rules of that stock exchange or between such parties or such terms as specified by the Central Government.”[xxvi] The contention put forth by SEBI regarding the unenforceability of put options is that they are in violation of § 18A of the SCRA as they are not entered on the stock exchange but are entered between two private parties. However, it has to be understood that the provision would only come to apply if it is the option (not the underlying shares) that is sold to another person.
SEBI by virtue of a letter had previously clarified that put options would not considered to be a valid derivative contract under § 18A of the SCRA as the same is entered explicitly between two parties and not a contract traded according to the condition laid down in the section.[xxvii] However in 2019, a single judge bench of the Bombay High Court held that sanction under § 18A was not against entering into any kind of option per se but only for preventing from trading the option as a security itself.[xxviii] The Learned judge held that the section does not explicitly invalidate any contract but only validates agreements that satisfy the conditions specified therein. Therefore, to declare a contract as being conclusively illegal or invalid, one would have to look outside the ambit of the section. It was highlighted that the section is transparent in what it entails and does not mean to say anything which it does not include.[xxix]
The same was reiterated in Banyan Tree Growth Capital LLC v. Axiom Cordages Ltd.[xxx] as the Court held that the option at the discretion of Banyan Tree was in the nature of a buy-back agreement which could possibly be traded or dealt on the stock exchange, and so was not in violation of the provisions of SCRA. Further, recently the division bench of the Bombay High Court upheld the decision of the single judge challenged before it in Percept Finserve Private Limited v. Edelweiss Financial Services Limited[xxxi]. It was clarified that only because an agreement possesses a put option regarding securities, it cannot be said to be a contract or trade in derivatives. What the law aims to proscribe is trading an option by treating it as a security not options in general.[xxxii] The decision also shed light on the fact that the October 2013 Notification would be applicable if the underlying agreement had been executed prior to 2013.
The 2013 Notification is a step in the right direction towards making India an attractive avenue for investments. Initial reservations about options have finally been laid to rest by the Court by virtue of the MCX Judgment and the recent Percept Finserve Judgement. The Percept Finserve Judgement is important as it has clarified that even the put options executed prior to 2013 are not prohibited by the SCRA. Thus, parties cannot hold out the execution of put options on the ground that they were executed prior to the 2013 Notification.[xxxiii]
The constantly evolving legal landscape in India regarding the enforceability of put options has not deterred parties from including such option clauses in their contracts.[xxxiv] Options, aimed at hedging risks, have becoming a necessity in the current paradigm. The beneficiaries are not only the investors exercising the option, but the security market at large. These contractual rights are essential to keep promoter opportunism in check and to ensure that funds invested by the private equity firms are utilized for the growth and development of the concerned company and investors are secure that their investment is protected.
[i] Harshad Pathak, Legality of Put Option under the Securities Contract Regulation Act, 1956, Ind. Student L.R. 128, (2013), (April 18, 2023), https://www.academia.edu/16606425/Legality_of_Put_Option_under_the_Securities_Contract_Regulation_Act_1956. [ii]Ibid. [iii] Indian Brand Equity Foundation, https://www.ibef.org/economy, (last visited April 18, 2023). [iv] Navin Parik, The Enforceability of Investor Rights in Private Equity in India, 117 taxmann.com 898 (2020), file:///C:/Users/shroo/Downloads/%20117%20taxmann.com%20898%20(Article)%20The%20Enforceability%20of%20Investor%20Rights%20in%20Private%20Equity%20In%20India.pdf. [v] SCRA, Central Government notification dated June 27, 1969: S.O. 2561. In exercise of the powers conferred by sub-section (1) of section 16 of the Securities Contracts (Regulation) Act, 1956 (42 of 1956) the Central Government being of the opinion that it is necessary to prevent undesirable speculation in securities in the whole of India, hereby declares that no person in the territory to which the said Act extends, shall save with the permission of the Central Government enter into any contract for the sale or purchase of securities other than such spot delivery contract or contract for cash or hand delivery or special delivery in any securities as is permissible under the said Act and the rules, bye-laws and regulations of a recognised stock exchange. [vi] Securities Laws (Amendment) Act, 1995 (that came into effect on January 25, 1995). [vii] Securities Laws (Amendment) Act, 1999 (with effect from January 22, 2000). [viii]Ibid. [ix]Supra note 1. [x] Securities and Exchange Board of India, Notification No. S.O. 184(E) (March 1, 2000). [xi] SCRA, Securities and Exchange Board of India, dated October 3, 2013, No. LAD-NRO/GN/2013-14/26/6667: 1. 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; 2. 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; and 3. the contract is settled by way of actual delivery of the underlying securities: Provided that the contracts specified in clauses (a) to (d) above, shall be in accordance with the provisions of the Foreign Exchange Management Act, 1999 and rules or regulations made thereunder: Provided further that nothing contained in this notification shall affect or validate any contract which has been entered into prior to the date of this notification. [xii] Reena Zachariah, SEBI ruling on Cairn deal may hit M&As of listed companies, The Economic Times, April 20, 2011, (April 18, 2023), https://economictimes.indiatimes.com/sebi-ruling-on-cairn-deal-may-hit-mas-of-listed-companies/articleshow/8032596.cms?from=mdr. [xiii]Shanmugham Pillai v. Annalakshmi, AIR 1950 FC 38; K. Simarathmull v. Nanjalingaiah Gowder, AIR 1963 SC 1182. [xiv]V. Pechimuthu v. Gowrammal, Appeal (Civil) 336 of 1997. [xv]Jethalal C. Thakkar v. R.N. Kapur, AIR 1956 Bom 74. [xvi]Ibid. [xvii] Nishkalp Investments and Trading Company Limited v. Hinduja TMT Limited,  143 Comp Cas 204 (Bom). [xviii]Supra note 17. [xix] “spot delivery contract” means a contract which provides for,— (a) actual delivery of securities and the payment of a price therefore either on the same day as the date of the contract or on the next day, the actual period taken for the despatch of the securities or the remittance of money therefore through the post being excluded from the computation of the period aforesaid if the parties to the contract do not reside in the same town or locality; (b) transfer of the securities by the depository from the account of a beneficial owner to the account of another beneficial owner when such securities are dealt with by a depository;] [xx]Supra note 17. [xxi]Rajshree Sugars and Chemicals Limited and Ors. v. AXIS Bank Limited and Ors., AIR 2011 Mad 144. [xxii]MCX Stock Exchange v. SEBI & Ors., 2012 SCC OnLine Bom 397. [xxiii] Supra note 21. [xxiv]Supra note 24. [xxv]Edelweiss Financial Services Ltd. v. Percept Finserve Pvt. Ltd., 2019 SCC OnLine Bom 732. [xxvi] Securities Contracts (Regulation) Act, § 18A (1956). [xxvii] Securities and Exchange Board of India, Letter No. CFD/DCR/16403/11 (May 23, 2011). [xxviii] Edelweiss Financial Services Ltd. v. Percept Finserve Pvt. Ltd., 2019 SCC OnLine Bom 732. [xxix]Ibid. [xxx]Tree Growth Capital LLC v. Axiom Cordages Ltd., 2020 SCC Online Bom 781. [xxxi]Percept Finserve Private Limited v. Edelweiss Financial Services Limited, 2023 SCC OnLine Bom 319. [xxxii]Ibid. [xxxiii] Bharat Vasani & Varun Kannan, Enforceability of Put Options under SCRA - Bombay HC’s latest judgment finally clears the air!, LEXOLOGY (last visited May 9, 2023), https://www.lexology.com/library/detail.aspx?g=c4824bca-8706-4c89-91c6-4fad5254fce8. [xxxiv] Vinod Joseph, Put Options - Enforcement And Claiming Damages & Indemnity, MONDAQ (last visited May 9, 2023), https://www.mondaq.com/india/Finance-and-Banking/860054/Put-Options--Enforcement-And-Claiming-Damages-Indemnity.