A Put Option Against a Resident: What Makes It Enforceable, and at What Price

A put option given by an Indian promoter to a foreign fund is enforceable in India. That has been the position since 2013, and the question on a current term sheet is not whether the option is good but which of three tests it has been drafted against. Securities law asks whether an option over securities is a lawful contract at all. Exchange control asks when the non-resident may exit and at what price. Company law asks whether the restriction reaches anyone beyond the two parties who signed it. The options that fail are the ones written carefully against one test and silently against the others.

The securities law question, answered in 2013

For years the objection to an option over shares was that it was a contract in securities other than a spot delivery contract, and so hit by the prohibition under the Securities Contracts (Regulation) Act, 1956. The Securities and Exchange Board of India closed that argument by notification on 3 October 2013, issued under sections 16 and 28 of that Act, which permits a contract for pre-emption or an option in a shareholders agreement or in the articles, subject to three conditions on its face.

The first is a holding period. The notification requires that

the title and ownership of the underlying securities is held continuously by the selling party to such contract for a minimum period of one year from the date of entering into the contract

The second is price. The consideration must be

in compliance with all the laws for the time being in force as applicable

which is not a formula but a cross-reference, and for a transaction with a non-resident it points straight at the exchange control position below.

The third is settlement. The contract must be

settled by way of actual delivery of the underlying securities

Taken together, these make an option a permitted contract rather than a wager on a price. The holder must have owned the shares for a year and must deliver them. What the notification does not do is tell a foreign investor what it may be paid.

The exchange control question, and the sentence that governs it

Where the option holder is a non-resident, the Reserve Bank of India's A.P. (DIR Series) Circular No. 86 of 9 January 2014 sets the terms on which an optionality clause may sit in a foreign investment. It permits such clauses without the instrument losing its character as equity, subject to a lock-in and to a ceiling on the exit price, and it states the principle behind both:

The guiding principle would be that the non-resident investor is not guaranteed any assured exit price at the time of making such investment/agreement

The lock-in is a

minimum lock-in period of one year or a minimum lock-in period as prescribed under FDI Regulations, whichever is higher

and the exit price depends on what is held. For a listed company, the investor may exit

at the market price prevailing at the recognised stock exchanges

For equity shares of an unlisted company, the exit is

at a price not exceeding that arrived at on the basis of Return on Equity (RoE) as per the latest audited balance sheet

and for compulsorily convertible debentures or preference shares the instrument is

transferred 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

Two drafting consequences follow, and they are the ones most often missed. A put struck at cost plus a fixed internal rate of return is an assured price, and the exchange control objection to it does not depend on whether the money ever moves. And a put exercisable at any time is not a put exercisable in the first year, so a clause that says the option runs from closing has to be read with the lock-in rather than against it.

The rule-making power over non-debt instruments moved to the Central Government in 2015, so on a live deal the current text to check is the rules made under the Foreign Exchange Management Act, 1999 for non-debt instruments, and not only the circular that first stated these conditions. The principle in the sentence above has not changed.

The company law question, which is about who is bound

The third test is the one that decides what the option is worth in a dispute. An agreement between shareholders restricting the transfer of shares binds the parties to it. The Bombay High Court, sitting in Division Bench, held in Messer Holdings Limited v Shyam Madanmohan Ruia on 1 September 2010 that a right of first refusal in a share purchase agreement was enforceable against the party who had agreed to it, and that a transfer made in breach of that clause was a breach the court would recognise.

What that leaves open is the company. A restriction that lives only in a contract is a matter between the signatories, and a company that is not a party is under no obligation to police it. Putting the restriction in the articles is what makes the company notice it, and the choice between the two is a choice about remedy: damages against a promoter who sold, or a transfer the company should not have registered.

What this means for a term sheet

Four questions, and they are cheaper to answer before signature than after.

What is the exit mechanism: a put at a price, or a put at a price to be determined by a method. The second survives the exchange control test and the first usually does not.

When does it become exercisable, counted from the date the agreement was entered into rather than from the event that triggers it.

What is the ceiling on the day of exercise, which for unlisted equity is a figure out of the latest audited balance sheet and therefore a figure that moves with the accounts rather than with the bargain.

And where does the restriction live. A clause in the agreement alone is enforceable between the parties. A clause in the articles is the one the company has to act on.

An option that answers all four is ordinary commercial drafting. An option that answers the first three and not the fourth is a claim for damages dressed as a security.