Column: Freeing up options

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SummarySince put and call options are a standard way to protect investors, Sebi’s move comes as a big relief

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 circular’s 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 today’s 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 shouldn’t have) but also outlawed legitimate commercial transactions (which it definitely shouldn’t 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.

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