SEBI allows shareholders’ options/pre-emptive rights

The question as to a shareholder’s right to enter into a private arrangement in relation to transfer of shares of a public company was resolved by a decision of Bombay High Court in Messer Holdings Limited v Shyam Madanmohan Ruia and Ors (September 2010), which held that a right of first refusal in a share purchase agreement was valid and not in violation of section 111A of the Companies Act, 1956. This decision by a division bench overruled a single bench judgment of the same court in Western Maharashtra Development Ltd v Bajaj Auto Ltd (February 2010), in which pre-emptive rights over shares of a public company were held to be illegal.

The legal proposition laid down in Messer Holdings in respect of transfer of shares of a public company has been given statutory recognition in the proviso to section 58(2) of the Companies Act, 2013, which provides that “any contract or arrangement between two or more persons in respect of transfer of securities shall be enforceable as a contract”. This provision implicitly provides legal sanctity to put and call options.

SEBI notification

The Securities and Exchange Board of India (SEBI), after taking an unfavourable stand towards options for many years, by way of a notification dated 3 October 2013, has rescinded its previous notification dated 1 March 2000 which restricted the scope of permissible securities contracts to spot delivery and derivative contracts. Now SEBI has broadened the scope of permissible securities contracts by permitting contracts for: (a) pre-emption including right of first refusal or tag-along or drag-along rights contained in shareholders agreements (SHA) or articles of association (AOA) of companies or other corporate bodies; and (b) contracts in SHA or AOA for purchase or sale of securities pursuant to exercise of an option contained in the SHA or AOA to buy or sell the securities, provided (i) the title and ownership of the underlying securities are held continuously by the selling party to such contract for a minimum of one year from the date of entering into the contract; (ii) the price or consideration payable for the sale or purchase of the underlying securities pursuant to exercise of any option contained in the SHA or AOA is in compliance with all the laws for the time being in force; and (iii) the contract is settled by way of actual delivery of the underlying securities.

The new notification is prospective in nature and requires contracts to comply with foreign exchange regulations.

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Analysis

SEBI seems to have considered the necessity of options and pre-emptive clauses in commercial arrangements in relation to shares of a public company and through the issuance of the 2013 notification has put at rest the controversy as to legitimacy of such options in the Indian context. In the past, SEBI has in many cases – including MCX Stock Exchange (April 2010), Vedanta Resources and Cairn Energy (April 2011), Vulcan Engineers (May 2011) – outlawed clauses in agreements dealing with forward contracts such as buy-back arrangements and put and call options.

At the same time, it is to be noted that while such securities contracts have now been declared to be valid on fulfilment of certain conditions, issues as regards mode of settlement and tradability have been left largely open. Some of the questions that can be contemplated are whether options would be settled as spot delivery contracts and whether pre-emptive rights in addition to options will be traded as marketable securities. In view of such uncertainty, a clarification would be most welcome.

However, a clear intent is manifested to prevent speculation in all circumstances since for a contractual option to be valid and enforceable, the securities must be held continuously for at least one year and the contract must be settled by actual delivery of the underlying securities. In addition, the notification is prospective in nature and accordingly any contract executed prior to notification remains unaffected.

The way forward

Though SEBI has permitted options and pre-emptive contracts, clarity and a formal notification is required from the Reserve Bank of India (RBI) in respect of such contracts since they are subject to foreign exchange regulations under the notification. As the RBI and the Department of Industrial Policy and Promotion have in the past looked at such contracts with suspicion and construed them as external commercial borrowings, it is imperative that the RBI as well as the Ministry of Corporate Affairs issue a clarification to remove the uncertainty that still lurks in the mind of all investors. Consistency, clarity and consensus is much needed across various sectoral regulators so that ambiguity with respect to such contracts is effectively dealt with.

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Ranjana Roy Gawai is the managing partner and Krishna Keshav is a partner at RRG & Associates.