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THE LEGALITY OF PUT OPTIONS UNDER SECURITIES CONTRACT REGULATION ACT 1956

Author: Charishma.K.S, II year of B.A.,LL.B.(Hons.) from Dr. Ambedkar Global Law Institute.


The securities contracts regulation act 1956 was enforced on 28 February 1957 to control the working of stock exchange in India and prevent the undesirable changes in securities, to protect the interest of investors in securities. The SCRA explains more difficult terms such as derivatives, securities, specific and spot delivery contracts. The provisions of SCRA play a major role in the stock market which helps initialize funds from small savings of the investors and channelization such resources into different developmental needs of sectors in the Indian economy. Generally, there are two options in the stock market. The layman's definition of options in the stock market is "An option is a contract, but not an obligation which allows investors to buy or sell an underlying instrument lines stock or index at a specific time or date. There are two types of options such as Put option and the Call option. A put option is a contract granting the owner the right but not an obligation to sell or sell short at a specified amount of an underlying asset at a predetermined price within a specific time. When an investor purchases a put, he wants the underlying stock to decline in price. Under section 2(d) SCRA is "option in securities” means a contract for the purchase or sale of a right to buy or sell, or a right to buy and sell, securities in the future, and includes. The "legality of put option", has been a controversial topic observed by judicial authorities. This paper elucidates the legislative framework for putting options with relevant case laws.


Legislative Framework

Currently, many regulatory bodies are securing the Indian securities market. They are :

  • Securities Exchange Board Of India (SEBI)

  • The Reserve Bank Of India (RBI)

  • The ministry of finance

  • The ministry of corporate affairs


Among all these, the SEBI is responsible for the growth and regulation of the Indian securities market. The central bank of India is "RBI (Reserve Bank Of India) " which is responsible for monetary policies including foreign exchange regulation. The third is the Government of India which regulates the legal framework of put options. The problem of unenforceability of put options began when the Indian government declared contracts for sale or purchase of securities other than spot delivery contracts or contracts settled through the stock exchange are void. In addition, The Government of India omitted section 20 of The SCRA 1956 by declaring it as illegal and void. These two notions led to many debates and endless controversy on the validity of put options. The Government of India, Securities Exchange Board of India, RBI made a unique approach to analyze options under SCRA "1956". The main reason for opposing the put option as legal is it does not qualify as derivative contracts and spot delivery contracts under section 2(a) and section 2(i) of SCRA respectively. In derivatives contracts, they can be only traded on the stock exchange and not through private contracts between parties and so the put option appears to be a privately contracted option that allows the parties to exercise a right to put of call at a future date in time that does not qualify as a valid or spot delivery contract. In a spot delivery contract, the transfer of money and shares occurs on the same day at the same time as the contract. The primary concern of RBI is that the use of options by the foreign investor may lead to volatility through the outflow of foreign exchange. The SEBI prohibited the use of options in agreement the Central Government delegated the power under Section 16 of the SCRA to SEBI by a notification of 1999. Later, the 2000 notification repealed the 1969 notice by introducing Section 18 (a) to SCRA which provided that, notwithstanding anything incorporated in any other law for the time being force, derivatives contracts will be treated as legal, if they are traded and resolved through the stock exchange after complying with all norms and bye-laws. The SEBI also published a notice similar to the notice of 1969. Therefore, the introduction of section 18 clarified investors and authorities about the derivatives that are those derivatives that do not form wagering contracts under section 30 of the Indian Contract Act, 1872. In the case of the Cairn and Vedanta merger and Diageo and United Spirits merger, Again, in 2011 the SEBI issued informal guidance to volcano engineers limited wherein it restated that only derivatives and spot delivery contracts are valid and put options do not come under the category of spot delivery contract. Thus, options were as forward contracts or derivatives by SEBI and didn't enforce under SCRA. Till 2013, the legality of the put option was in question, in 2013 the SEBI issued a notification to expand the scope of permissible contracts under the securities contracts regulation 1956 to include option contracts in its sphere. The 2013 notification claimed that the trading of option contracts would be legal in agreements of Articles of Association of various companies and shareholders if it follows certain conditions. Conditions for the validity of put options are: :


  1. The minimum period for the holding of ownership and title of the underlying securities by the seller should be one year from the date on which the contract is entered into.

  2. The amount which is due on sale or purchase of derivatives under the exercise of any option contained therein should comply with all the laws.

  3. The mode should be actual delivery to settle the contract of underlying securities. These contracts of underlying securities have to follow the provisions of the Foreign Exchange and Management Act,1999.


The SEBI clarified in its 2013 notification that according to section 18-A of SCRA (which was introduced in 2000 notification of SEBI) if derivatives are traded as per the norms and bye-laws of a recognized stock exchange and resolved by the recognized stock exchange on the clearinghouse then contracts in derivatives will be legal in the eyes of law and hence are enforceable.


Nature of put options by Judicial decisions

In 2005, the Bombay High Court, while dealing with a buy-back clause in a share purchase agreement, held that such a clause would be illegal under the SCRA because it is not a spot delivery contract. In 2012, the Bombay High Court, while dealing with options for the purchase or sale of securities between the parties, in the case of MCX Stock Exchange Limited vs. SEBI, held that options are simply the right of the option holder, and a finalized contract for the sale and purchase comes into the existence only when the option holder exercises his option. The court also clarified between a futures contract, which was a contract for the purchase or sale of securities in the future at a determined price, and options, which were mere privileges in the hands of the option holder. However, the SEBI filed appeal by way of a Special Leave Petition was dismissed by the Supreme Court since it does not satisfy Article 136 of the Constitution and t based on the consent terms documented by the parties. In 2019, The Bombay High court passed a similar judgment as of MCX stock exchange v.SEBI in Edelweiss Financial Services Ltd v. Except Finserve Pvt Ltd. And ensured the validity of put options under SCRA, 1956.


Conclusion

As per the 2013 notification, it can be said that put option contracts are valid if it is compiled with certain conditions. Even, the. Bombay High court cleaned out the questions regarding the legality of options was a dubious question in the judgment of MCX Stock Exchange v. SEBI.


Reference

1. https://www.sebi.gov.in/acts/contractact.pdf

2. https://www.researchgate.net/publication/270159497_Legality_of_Put_Option_under_the_Securities_Contract_Regulation_Ac

3.https://www.ndtv.com/business/stock/edelweiss-financial-services-ltd_edelweiss

4. http://corporatelawreporter.com/2013/10/04/sebi-notification-section-16-28-securities-contracts-regulation-act-1956/

5. https://indiankanoon.org/doc/101113552/