Column: Freeing up options

Written by Sandeep Parekh | Updated: Oct 4 2013, 10:30am hrs
Sebi has finally put an end to the uncertainty that has haunted investors for several decades. It all began with the circular of 1969 passed under the Securities Contracts (Regulation) Act which virtually banned all forwards and options in securities. Spot delivery contracts, contracts traded on exchange, certain pre-emption rights, warrants and convertibles, and securities of private limited companies were the few exceptions to the otherwise overarching ban. While the original circular was not used much to invalidate contracts, over the past two decades and in particular the past five years, more and more genuine commercial contracts were being challenged in courts of law stating that the contracts were in violation of this prohibition. Sebi had hitherto held that transactions involving options which may be exercisable at a future date would be invalid and would not be considered as a spot delivery contract. Therefore, a contract to buyback shares in the future was not valid and enforceable until today. This position was confirmed through the informal guidance in the matter of Vulcan Engineers Ltd.

Although, there was some speculation in the year 2000 that the repeal of the 1969 circular and omission of Section 20 of the SCRA may pave the way for validating the enforceability of options, such hopes were soon shattered with Sebi issuing a notification in the same year which brought back the 1969 circulars ban back to life.

The original intent of the prohibition was in fact an attempt to curb speculative transactions off exchanges including in shadow exchanges. The aim was to prohibit what used to be called dabba trading, usually carried out at a corner street near formal exchanges. In todays world, speculation is no longer a dirty word, and nearly all economists would agree that speculators not only provide liquidity and price discovery in the market, but often offer trades on the other side of hedgers. But in its broad drafting, the circular ended up hurting genuine transactions. This prohibition was detrimental because it not only outlawed speculative trades (which anyway it shouldnt have) but also outlawed legitimate commercial transactions (which it definitely shouldnt have).

A majority of private equity investments have various put and call options in the shareholder agreements as a common means of protecting their investments against the dominant interest of promoters. This uncertainty lurked over hundreds of investment agreements, private equity deals, joint venture agreements and other commercial contracts.

Sebi in yesterdays notification under Section 16 of the Securities Contracts (Regulation) Act has finally removed uncertainty regarding the issue by rescinding the notification dated March 1, 2000. Although the new notification would be applicable prospectively, it brings a sigh of relief to thousands of investors who were apprehensive about bringing their money to India not to mention thousands of domestic contracts of investments. The notification provides that spot delivery contracts, contracts for sale or purchase of securities or contracts in derivatives and 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 corporates would now be valid and enforceable. Thus, contracts entered into after today will subject to some conditions, get the protection from the prohibition.

In relation to 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, Sebi has prescribed three conditions:

*The title and ownership of the underlying securities is held continuously by the selling party for a year.

*The price or consideration must be determined in compliance to all laws.

*There must be actual delivery of the underlying securities for the settlement of the contract.

Subject to the fulfilment of these three conditions, such contracts would be valid and enforceable. These conditions are probably intended to ensure that the transactions are genuinely commercial since ownership for a period and actual delivery would minimise the chance of them being categorised as speculative. Similarly, there is an emphasis on transparency, fairness and conformity with the law.

There are still two areas of concern. One, the circular is not clear whether this new law applies to securities of public unlisted companies or not. Given several Supreme Court rulings which have explored this question, till now, the courts have interpreted the prohibition broadly and thus options even in unlisted shares of a public company have been captured within the sweep of the 1969/2000 circular. Sebi lost the chance to clarify and restrict the scope of the prohibition to only listed securities. Extending the prohibition to unlisted securities does not serve any purpose, and the courts have only interpreted the provisions as they exist in the prohibition. It would have been a progressive move to restrict the prohibition to only listed securities where there is any public concern. The second area of concern is that the lifting of the prohibition is only prospective. This would mean that past agreements by joint venture partners, private equity investors, domestic investors would all still face the challenge of the old and perverse prohibition. This should have ideally been avoided, as all investors ought to have been allowed the protection of the new law. However, there is scope for some creativity by lawyers in this respect. It would be easy to tear the old agreements and draw up new and identical ones which would protect the investors from the prohibition.

In a nutshell, this notification has introduced the much needed and much awaited certainty that was required for various genuine commercial contracts which were being hampered by the excessively suspicious attitude of the regulator. But of course like all other things, it could have been even better.

The author is the founder of Finsec Law Advisors