IVS Presentation on the Legality of Call and Put options

an assignment on call and put options and its legality

1. LEGALITY OF PUT OPTION UNDER THE SECURITIES CONTRACT REGULATION ACT, 1956

2. Options are very popular exit mechanisms in India and various other countries. They are often found in different types of transaction structures like angel investors, private equity, joint ventures, venture capital, etc. In India, the Securities Exchange Board of India, The Reserve Bank of India, The Ministry of Finance, The Ministry of Corporate Affairs take care of the rules and regulations for option trading. According to Securities Contract Regulation Act, 1956 section 2(d) “option in securities” means a contract for the purchase or sale of a right to buy or sell, or a right to buy and sell, securities in future, and includes… a put, a call or a put and call in securities. Options are the derivatives contracts . Option in securities is of two types- call option and put option. The call option is a right of buying the shares at a future date but a predetermined price. The put option is a right of selling the securities or shares at a future date but at a predetermined price. INTRODUCTION:

3. PROBLEM PROFILE:   Time and again, it has been observed by relevant judicial authorities that options are not legally enforceable in India . This is because only certain specified transactions in securities are permissible . One of the permissible transactions in securities is a spot delivery contract‟. This presentation intends to analyze the legal validity of put options under the Securities Contract Regulation Act, 1956 (“SCRA”); and simultaneously put forth the view that such options amount to spot delivery contracts; and are, therefore, enforceable in law. Such contracts, alleged to be speculative, are thus, rendered unenforceable. It is this proposition that the presentation endeavours to negate . The judicial opinion, declaring options as forward contracts is not only erroneous but based upon an incomplete understanding of the meaning and scope of securities. RESEARCH METHODOLOGY : The researcher relied on the doctrinal method of research to complete this project.

4. OBJECTIVES:   To analyse option contracts through the SEBI notification, 2013. To scrutinise the legal position of option contracts in the light of MCX Stock Exchange Ltd. v. SEBI. To briefly analyse the judicial decisions on the nature of put options. RESEARCH QUESTIONS: Whether put options are legal? What is the rationale behind imparting legality to option contracts? What is the current position of put options in the securities market?

5. HISTORY: The legal position with respect to enforceability of put option clauses has not been a glorious chapter in the history of India’s securities law. The genesis of this vexed issue lies in – ( i ) the  erstwhile   Section 20 of the Securities Contracts (Regulation) Act, 1956 (“ SCRA ”) which had provided that all options in securities shall be illegal; and (ii) a notification issued by the Ministry of Finance in 1969, which  inter alia  provided that any contract for sale or purchase of securities, other than such spot delivery contract or contract for cash or hand delivery or special delivery in any securities shall be prohibited. (“ 1969 Notification ”). Further, this section was omitted. On March 1, 2000 , to replace the 1969 Notification, SEBI issued a fresh notification which prohibited the entering of any contract for sale or purchase of securities, other than spot delivery contracts, contracts for cash/hand delivery/ special delivery, and derivatives contracts

6. (“ March 2000 Notification ”). As the March 2000 Notification was not happily worded, the ambiguity surrounding the enforceability of put/ call option clauses continued. SCRA was also amended in 1999 , to introduce Section 18A , which provides that notwithstanding anything contained in any other law for the time being in force, contracts in derivatives shall be legal and valid if such contracts are (a) traded on a recognised stock exchange; (b) settled on the clearing house of the recognised stock exchange, in accordance with the rules and bye-laws of such stock exchange; or (c) between such parties and on such terms as the Central Government may, by notification in the Official Gazette, specify Securities Laws (Amendment) Act, 1999. Subsequently, to clarify the legal position, SEBI issued a notification on October 3, 2013 , which rescinded the March 2000 Notification, and for the first time, permitted contracts in shareholders agreements or provisions in the articles of association, providing for a put/ call option (“ October 2013 Notification”). The October 2013 Notification permitted put/call option clauses subject to satisfaction of the following conditions:

7. the title/ ownership of the underlying securities is held continuously by the selling party for a minimum period of one year from the date of entering into the contract; the price/ consideration payable for sale/ purchase of the underlying securities pursuant to exercise of the option is in compliance with applicable law; 3. the contract is settled by way of actual delivery of the underlying securities; the contract is in compliance with FEMA . It is relevant to note that the October 2013 Notification provides that nothing contained in the said notification “ shall affect or validate any contract which has been entered into prior to the date of this notification ”.

8. JUDICIAL DECISIONS ON THE NATURE OF PUT OPTIONS: If we talk about the nature of the options, options are considered as a contingent contract that means they will become contract only on the event of actual sale or purchase. Hence, options belong to the category of contingent contracts. In the Jethalal C Thakkar v. R. N. Kapur ,  AIR 1956 Bom 74 a question arose before a Bombay High Court that whether contingent contracts belong to the category of ready delivery contracts. Ready delivery contracts are considered valid or legal under the Bombay Securities Contracts Control Act, 1925. Hence, Bombay HC concluded that where there no present obligation exists in contracts for purchase or sale of shares, and if due to some condition obligation arises then the occurrence of any contingency would be valid and such contracts would fall within the scope of ready delivery contracts . Because of the similarity between the nature of ready delivery contracts and put options, it was interpreted in this case that put options would be enforceable in law . ARE OPTIONS SPOT DELIVERY CONTRACTS?

9. Whether put options results in a spot delivery contract? The right to sell to an assured a buyer at a pre-determined strike price g ets transferred to the buyer of a put option the moment the agreement comes into force. Such a right, amounting to constructive securities , therefore, it gets actually delivered on the same day as that of making the contract . Consequently, as long as the payment of price is made on the same day, a put option ought to be considered as a spot delivery contract.

10. JUDICIAL DECISIONS ON THE NATURE OF PUT OPTIONS:

11. MCX STOCK EXCHANGE V SEBI, (201) WTM/KMA/MRD/296/09/2010 (SEBI) On August 12, 2008 MCX SE had filed an application before the SEBI to operate as a stock exchange. In 2008 the SEBI granted an in-principal approval to MCX SE for the same, subject to full compliance with the provisions of the MIMPS Regulations . In order to comply with this, MCX SE and its promoters undertook various measures including entering into arrangements with the banks for preferential issue of shares to PNB and to reduce the shareholdings of the promoters of MCX SE . PNB was offered an exit option in the form of a buy back arrangement. Each of the options had a fixed exercise period and also included an IRR component . On September 23, 2010 the Whole Time Member of SEBI passed the SEBI Order rejecting the application primarily on the grounds of MCX SE failing to comply with modes of reducing promoter shareholding and non-disclosure of the Option arrangements to PNB and the illegality thereof on the ground that they were in the nature of forward contracts not valid and legal under the SCRA.

12. JUDGEMENT: T he Bombay High Court held that a buyback agreement confers an option on the promisee and no contract for the sale or purchase of securities is concluded until such option is exercised by the party holding the option. If such option is not exercised by the Option Holder, no contract for sale or purchase of securities would come into existence and the Option Writer cannot compel performance of the contract. The Bombay High Court further distinguished an ‘option contract’ from a ‘forward contract’ stating that while the latter involves a contract for the purchase and sale of securities in the future at a specified price, the nature of an option is that of a privilege and a contract to purchase and sell securities can only be concluded by exercising the option, and thus the two could not be equated .

13. Percept Finserve Private Limited v. Edelweiss Financial Services Limited, 2023 SCC OnLine Bom 319 Factual Matrix Edelweiss and Percept Finserve entered into a SPA to purchase 2,28,374 shares of Percept Limited, that were held by Percept Finserve , for a consideration of INR 20 Crores. The SPA contained certain  conditions subsequent  that had to be fulfilled by Percept Limited and Percept Finserve including an obligation to restructure the Percept group. On non-fulfillment of the same, Edelweiss was entitled to resell the shares to Percept Finserve , for the amount that would yield an internal rate of return (“ IRR ”) of 10% of the purchase consideration (“ Edelweiss Put Option ”).

14. As the  conditions subsequent  were not fulfilled even as per the extended timeline, Edelweiss exercised its put option, and issued a letter calling upon Percept Finserve to give effect to the Edelweiss Put Option by January 12, 2009.  As Percept Finserve did not honour the exercise of the Edelweiss Put Option, Edelweiss commenced arbitration proceedings, contending that upon breach of the SPA, Edelweiss was entitled to exercise the Edelweiss Put Option as an exit mechanism. The sole arbitrator held that the Edelweiss Put Option was not permitted under the SCRA, as – (a) it constituted a forward contract that was prohibited under Section 16 of the SCRA read with the March 2000 Notification; and (b) the Edelweiss Put Option was an option concerning a future purchase of shares that were not being traded on a recognised stock exchange, and was accordingly prohibited under Section 18A of the SCRA .

15. The Division Bench held that merely because Percept Finserve was given an option to complete re-purchase of securities with immediate effect, and in any case before a specified future date, it cannot be said that the contract for re-purchase was not on a spot-delivery basis – as there was nothing to indicate any time lag between the payment of price and the delivery of the shares. The Division Bench also referred to an earlier decision of the Bombay HC in  MCX Stock Exchange Limited v. SEBI ,  which held that an ‘option’ is in the nature of a  privilege , the exercise of which is dependent on the discretion of the person who has been granted the option. In case of an option, a concluded contract arises only upon  exercise  of the option and thus such a contract is not a forward contract-forward contracts are not regulated under SCRA . . JUDGEMENT:

16. RESTRICTIONS ON ENFORCEMENT OF PUT OPTIONS UNDER THE FEMA Notwithstanding their commercial utility, their incorporation in agreements leads to legal complications as India’s foreign investment regulations prohibit such agreements.  Rules 9(5) and 21(2)(c)(iii) of FEMA (Non-Debt Instruments) Rules, 2019   govern the pricing mechanism of equity shares transferred to a person resident in India from a person resident outside India . It states that the exit price provided to investors cannot exceed the valuation carried out according to any internationally accepted pricing methodology for valuation on an arm’s length basis certified by a chartered accountant. This value is called the fair market value (FMV). The explanation to the rule adds that a person resident outside India cannot be guaranteed an “assured exit price” when investing in the company. This rule poses difficulties for enforcing put options with an IRR construct as that guarantees the investor an assured exit price. RESTRICTIONS ON ENFORCEMENT OF PUT OPTIONS UNDER FEMA:

17. CONCLUSION: Options, by transferring a right to purchase or sell securities in future, at a pre-determined strike price, reduce the amount of risk that comes with any investment and such contracts are nine cases out of ten, ranging in millions of dollars. The subject matter of a Put Option is not shares, stocks, debentures etc. but necessarily the right to purchase the same at a future point of time, for a fixed strike price. These rights are to be considered as “securities‟ themselves within the ambit of the SCRA. As elaborated earlier, there is an actual delivery of securities taking place in a Put Option. The possession of the rights involved gets “actually ” delivered to the purchaser of such Option at the very instant an agreement to the same comes into force. The actual delivery is immediate, subject to the conditions of the contract, and takes place the moment the dotted line is signed by both the parties. Drawing from this , it may not be a herculean task to identify and acknowledge that the ultimate beneficiaries in the proposed scenario are not only the plethora of investors purchasing a Put Option, but the market itself and this a stop must be put to contesting its legality.