Put and call options: Recent Legal and Regulatory Developments

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1 January 2014 Put and call options: Recent Legal and Regulatory Developments 1. Background: Significance of option contracts 1.1 Put and call options on Indian securities (issued by both public and private companies) have been fairly common in the market, if less so in the more recent past. 1.2 Private equity investors have used put options as one of the means to exit an investee company (usually if other modes of exit, such as an initial public offering, have failed) while joint venture partners have used put and call options as a method of deadlock resolution by buying out the other partner. In sectors that have a cap on foreign investment (such as telecommunication and insurance), foreign investors have entered into option contracts with their Indian joint venture partners to enable them to increase their stake if and when the sectoral caps are liberalised. Contents 1. Background: Significance of option contracts Enforceability and legality: Restrictions under Indian law Recent liberalisation: Conclusion: Impact of the changes Enforceability and legality: Restrictions under Indian law While put and call options have been fairly common in the Indian market, the legality and enforceability of such contracts has been in doubt due to certain statutory and regulatory restrictions applicable to them. These restrictions can be broadly classified as follows: 2.1 Restrictions under company law: The Companies Act, 1956 required that shares of all public companies be freely transferable 1. There was, however, a view that an option contract was in the nature of a restriction on free transferability and was therefore void for violating the Companies Act, This restriction was applicable only to public companies and would not, as such, apply to shares of a private company. 2.2 Restrictions under securities control regulations: The Securities and Exchange Board of India ( SEBI ) had prohibited all contracts for sale or purchase of marketable securities other than spot delivery contracts 2 or contracts for cash or hand delivery or special 1 2 Section 111A, Companies Act, Spot delivery contracts are contracts requiring actual delivery of securities and payment either on the same day as or the next day after the date of the contract. 1

2 delivery. 3 Put and call options on listed securities were considered illegal because they did not satisfy these requirements The Securities Contract Regulation Act, 1956 ( SCRA ) also prohibited all derivative contracts except those that were traded and settled on a recognised stock exchange. Options, being in the nature of derivative contracts, were deemed to be illegal unless they were so traded and settled SEBI, in a few instances 4, has required parties to amend existing contracts to remove options on shares of the underlying company In light of certain judicial pronouncements, the same restrictions were deemed to be applicable to shares of unlisted public companies as well. These restrictions were of general application and not limited to instruments purchased or subscribed to by foreign investors. However, they were not applicable to shares of a private limited company Some practitioners were of the view that option contracts, being contingent contracts, come into existence only upon exercise of the option, and if paid and settled within 1 day of the option exercise notice, would qualify as a spot delivery contract. However, this view was not free from doubt and in any event, did not address the restriction applicable to derivative contracts Restrictions under exchange control regulations: In 2007, the Reserve Bank of India ( RBI ) and the Department of Industrial Policy and Promotion of the Government of India ( DIPP ) issued circulars stipulating that only equity shares and fully and compulsorily convertible preference shares and debentures ( CCPs and CCDs respectively) would qualify as eligible instruments for foreign direct investment. Any instrument with in-built optionality (e.g. optionally convertible debentures) was considered to be in the nature of debt and had to comply with the regulations governing external commercial borrowings Prior to these notifications, foreign investors were permitted to invest through instruments such as optionally convertible preference shares and debentures which essentially provided them a minimum guaranteed return on their investment. The purpose of these notifications was to ensure that foreign investors investing through the foreign direct investment route would take a genuine equity risk in the underlying company and not get the benefit of any guaranteed returns While these notifications dealt only with the nature of instruments and did not introduce any express prohibition on a third party option contract, RBI took the view (though it did not issue any general notification to this effect) that option contracts generally, even where the optionality was not inbuilt, resulted in the instruments being in the 3 4 SEBI notification no S.O.184(E) dated 1 March 2000 issued under the Securities Contract Regulation Act, A notable instance was the SEBI directives to Vedanta Resources and Cairn Energy.

3 nature of a fixed return debt instrument and were therefore not permissible under the foreign direct investment route. In some cases, RBI sought to take action against parties on grounds of violation of the Foreign Exchange Management Act, 1999 and rules or regulations made under it (together FEMA ) The Consolidated FDI Policy of October 1, 2011 issued by the DIPP stated that equity instruments issued or transferred to non-residents having in-built options or supported by options sold by third parties would lose their equity character and such instruments would have to comply with guidelines. This provision was deleted by the DIPP very soon after its inclusion, resulting in a view that option contracts were not violative of foreign direct investment policy. However, RBI maintained its previous stand and there was effectively no change in the treatment of option contracts by RBI under FEMA While these restrictions were limited to instruments purchased or subscribed to by foreign investors, they applied to instruments issued by public as well as private limited companies unlike the restrictions under the Companies Act, 1956 and SCRA discussed above. 3. Recent liberalisation: The last few months have seen a series of reforms on this matter which has changed the Indian legal position on option contracts New company law: The Companies Act, 2013 (which is now partially in effect) recognises 5 the validity of a contract in respect of transfer of securities. Therefore the restrictions under the Companies Act, 1956 have ceased to be applicable to option contracts on shares of Indian public companies SEBI reforms: In October 2013, SEBI permitted 6 option contracts in relation to public companies provided the following conditions were met: (a) the option contract would be incorporated in the shareholders agreements or articles of association of the underlying company (b) (c) (d) the seller under the option contract would continue to hold the title and ownership of the option securities for at least one year from the date of the option contract; the purchase consideration for the securities under the option contract would be in compliance with all applicable laws; the contract would be settled by way of actual delivery of the underlying securities; and 5 6 Proviso to Section 58(2), Companies Act, 2013, effective as of 12 September SEBI Notification No No. LAD-NRO/GN/ /26/6667 dated 3 October 2013 under the Securities Contract Regulation Act, 1956.

4 (e) the contract would be in compliance with the provisions of FEMA SEBI also clarified that the restrictions applicable to derivatives will not apply to option contracts that comply with the above conditions While this development relaxed the securities control restrictions on options, such permission was subject to compliance with the provisions of FEMA, and in the absence of any notifications from RBI, the lack of clarity remained in the context of foreign direct investment. 3.3 RBI reforms: Subsequent to the SEBI reforms, RBI has now permitted 7 shares and convertible debentures containing an optionality clause under the foreign direct investment route subject to the following conditions being met: (i) (ii) (iii) A foreign investor seeking to exit through an optionality clause will be subject to a minimum lock-in period of the higher of (i) one year, and (ii) any lock-in period specified under FEMA for that specific sector (e.g. 3 years for the construction and development sector). The optionality clause cannot assure a fixed or minimum return to the foreign investor. Any exit by a foreign investor pursuant to such option will meet the following pricing norms: (a) (b) (c) in case of a listed company, the exit shall be at the market price determined on the floor of the recognised stock exchanges; in case of equity shares of an unlisted company, the exit shall be at a price not exceeding that arrived on the basis of return on equity as per the latest audited balance sheet of the underlying company. Return on equity has been defined as profit after tax divided by the net worth of the underlying company. In case of preference shares or debentures, the exit shall be at a price worked out as per any internationally accepted pricing methodology at the time of exit, duly certified by a chartered accountant or a SEBI registered merchant banker. 4. Conclusion: Impact of the changes The above reforms have provided much needed clarity with regard to the legality and enforceability of option contracts going forward 7 RBI notification No FEMA 294/2013-RB dated 12 November 2013 (effective from 30 December 2013, the date of publication in the official gazette) and RBI Notification No RBI/ /436 A.P. (Dir Series) Circular No. 86 dated 9 January 2014.

5 (especially in the context of foreign direct investments). It is also now clear that investments in equity instruments coupled with a put option at a guaranteed price are not permitted under the Indian regulatory framework. However, a few areas continue to remain unclear: 4.1 Grandfathering of existing option contracts: The SEBI circular states that nothing contained in it shall affect or validate any contract which has been entered into prior to the date of the circular. The RBI circular dated 9 January 2014 however, states that all existing contracts will have to comply with the conditions set out in it to qualify as being compliant with foreign direct investment norms. Given the above, it appears that all existing option contracts in the context of foreign direct investment not complying with the norms now prescribed by SEBI and RBI shall be deemed illegal and unenforceable While the RBI circulars seem to indicate that existing contracts providing for options can be used under the new regime as long as the conditions imposed by RBI are complied with, it is not entirely clear whether the same approach would work from the perspective of the SEBI regulations. 4.2 Inbuilt options and third party options: The RBI circular permits shares or convertible debentures containing an optionality clause but without any option/right to exit at an assured price While the language of the circular is not entirely clear on this, given the long history and background to the issue, it is likely that the regulatory intent is for the permission to cover both (a) options for buyback or redemption by the investee company itself, and (b) option contracts with third parties (such as a promoter entity) However, in light of the language of the amendment, in our view it would be advisable (a) in case of CCPs and CCDs, to incorporate any third party option contracts in the terms of the instrument as well; and (b) in case of equity shares, to incorporate the terms of a third party contract in the subscription agreement or the articles of association of the underlying company Note that buyback by the investee company itself will be subject to other conditions under company law and, in the case of listed companies, SEBI regulations. 4.3 Pricing guidelines: Return on Equity basis Under existing regulations, a transfer of Indian shares by a foreign investor to a resident Indian buyer is subject to a maximum price which is the fair value be determined by a SEBI registered Category I Merchant Banker or a chartered accountant as per the discounted free cash flow method.

6 Contacts However, the RBI circulars on options provides that the exit price in case of equity shares being sold under an option shall be subject to a maximum price determined on the basis of return on equity as per the latest audited balance sheet of the underlying company The above leads to a situation where a transfer of equity shares from a foreign investor to a resident buyer would attract different pricing norms depending on whether the sale is under an option contract obliging such purchase or in other circumstances, and the rationale behind this distinction seems unclear. It is possible that the two tests will yield very different results in terms of the exit valuation available to the foreign investor However, the return on equity test has not been made applicable to a transfer of CCPs or CCDs, which may be transferred at a price determined as per any internationally accepted pricing methodology at the time of exit, duly certified by a chartered accountant or a SEBI registered merchant banker, so long as there is no pre-agreed return. From an investor s perspective, it is likely that investments in CCPs and CCDs would be preferable as there will be greater flexibility available on pricing for an exit. 4.4 Pricing guidelines: applicability to transfer between non residents While there is some ambiguity on this (since the RBI circulars do not expressly clarify whether the conditions set out in them apply only to a contract between a foreign investor and a resident buyer), given the background to the issue, the regulatory intent behind the prohibition on option contracts appears to be to prevent a foreign investor getting a guaranteed return on an equity investment from a resident counterparty and therefore a guaranteed price option contract between two non residents should not fall foul of the regulations. For further information please contact: Linklaters Narayan Iyer Partner, London (+44) narayan.iyer@linklaters.com Savi Hebbur Partner, London (+44) savi.hebbur@linklaters.com One Silk Street London EC2Y 8HQ, United Kingdom Tel: (+44) Philip Badge Partner, Singapore (+65) philip.badge@linklaters.com Aditya Shroff Counsel, Singapore (+65) aditya.shroff@linklaters.com One George Street #17-01 Singapore Tel: (+65) Linklaters.com This publication is intended merely to highlight issues and not to be comprehensive, nor to provide legal advice. Should you have any questions on issues reported here or on other areas of law, please contact one of your regular contacts, or contact the editors. The contents of this publication do not constitute any opinion or determination on, or certification in respect of, the application of Indian law, by or from Linklaters LLP or its affiliated firms or entities (together "Linklaters"). All content relating to Indian law and any comments concerning India are based on legal advice from Talwar Thakore & Associates taking into account, where applicable, Linklaters' transactional experience and understanding of the rules and regulations and the practice in India. Like all international law firms, Linklaters is not licensed to undertake Indian legal services. Linklaters LLP and Talwar Thakore & Associates. All Rights reserved 2014 Linklaters LLP is a limited liability partnership registered in England and Wales with registered number OC It is a law firm authorised and regulated by the Solicitors Regulation Authority. The term partner in relation to Linklaters LLP is used to refer to a member of Linklaters LLP or an employee or consultant of Linklaters LLP or any of its affiliated firms or entities with equivalent standing and qualifications. A list of the names of the members of Linklaters LLP together with a list of those non-members who are designated as partners and their professional qualifications is open to inspection at its registered office, One Silk Street, London EC2Y 8HQ or on and such persons are either solicitors, registered foreign lawyers or European lawyers. Please refer to for important information on our regulatory position. We currently hold your contact details, which we use to send you newsletters such as this and for other marketing and business communications. We use your contact details for our own internal purposes only. This information is available to our offices worldwide and to those of our associated firms. Please refer to for important information on our regulatory position. If any of your details are incorrect or have recently changed, or if you no longer wish to receive this newsletter or other marketing communications, please let us know by ing us at marketing.database@linklaters.com or marketing.database@tta.in. tt&a Kunal Thakore Partner, Mumbai (+91) kunal.thakore@tta.in Sonali Mahapatra Partner, Mumbai (+91) sonali.mahapatra@tta.in 3rd Floor, Kalpataru Heritage 127, MG Road Mumbai, Tel: (+91)