August 1, 2012

Put option- Enforceability in terms of law

Put option- Enforceability in terms of law

A “Put Option” is an Investor’s exit/liquidity option by way of which an Investor can, on the happening of a “Put Trigger” event, compel the promoter/ shareholder of Company to buy its shares either wholly or partly, at a valuation, agreed between the parties. A “Put Option” has become a popular exit option in business practice and has found expression by way was a “Put Option” Clause in Share Holders Agreement (SSA) or Share Subscription Agreements (SHA). But such seemingly standard exit rights may not always be enforceable under Indian law.

After a notification issued in 1969 under the Securities Contracts Regulation Act (SCRA), 1956, all transactions in securities other than on a “spot delivery” basis or unless settled through the stock exchange are illegal. Though this notification was repealed in 2000, another notification was issued on the same day, which was for the most part similar to the 1969 notification.

Question: Is a put option a spot delivery contract as is permissible under SCRA, or is it a forward contract and thus illegal?

Earlier view: A put option may not even be treated as a completed contract as it is more in the nature of a contingent contract. It would result in a contract for sale or purchase of securities only upon the exercise of the option and not merely upon the grant of such option. Further, once the option is exercised, the contract is typically performed immediately, that is, on a spot delivery basis and should thus be enforceable. This line of reasoning was accepted by the Bombay high court in the case of Jethalal C. Thakkar vs R.N. Kapur on 12 August, 1955 decided under the erstwhile Bombay Securities Contracts Control Act (BSCCA), 1925, an enactment that is broadly similar to SCRA.

Present view: In the recent decision of the Bombay high court in the Niskalp Investments and Trading Co. Ltd v. Hinduja TMT Ltd case in 2008 (Hinduja case) counters the above principle. In the Hinduja case, in accordance with the agreement executed between the parties for the purchase of securities, the purchaser was to be provided an exit by way of an IPO of the company, failing which the seller was to buy back the purchaser’s stake at a 20% internal rate of return. The seller did not honor its obligations under the agreement and consequently, the purchaser approached the courts. However, the court held in favor of the seller, stating that the arrangement to buy back shares is hit by SCRA and is thus void.

The court reached such a conclusion by relying on a summons for judgment passed F.I. Rebello, J. in Summons for Judgment No. 511 of 1997 in Summary Suit No. 4556 of 1996 being dated 6-4-1999, which, in turn, had relied on a ruling passed by the Supreme Court in the case of BOI Finance Ltd. v. Custodian [1997] 10 SCC 488 : 12 SCL 99.

Analysis: As long as put options are settled on a spot delivery basis, they should be enforceable, necessary amendments to SCRA or a clarificatory circular by the Securities and Exchange Board of India to this effect would be useful, especially in the prevailing market conditions. Until such time, rights such as put option rights and rights to cause the company to buy back shares, even if settled on a spot delivery basis, may be regarded as being unenforceable, more so in light of the ruling in the Hinduja case.

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