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Enforceability of Put Option Clause under SCRA Upheld by Bombay High Court

The Division Bench of Bombay High court, in the case of Percept Finserve Pvt. Ltd. v. Edelweiss Financial Services Ltd., held that a put option clause found in share purchase agreements is legally valid under the terms of the Securities Contracts (Regulation) Act of 1956^[1] (the “SCRA”).

Share Purchase Agreement (SPA)

​​A share purchase agreement (SPA) outlines the terms and conditions relating to the sale and purchase of shares and securities of a company listed on a stock exchange. This agreement is essential for preserving coherence between the buyer and seller because it provides important information, including shareholder rights, obligations, and other crucial elements. It would be easier to safeguard the interests of both parties concerned with this agreement. An option clause in a shareholder agreement describes the rights and obligations of shareholders. This provision allows shareholders the option to “call” or “put” the equity on the table, obliging the founders to buy or sell the equity at the specified price.

Put option clause 

In the year 2013, SEBI published a notice with the date October 3, 2013 (the “SEBI 2013 Notification”), which repealed the SEBI 2000 Notification and included option contracts to the list of contracts that the SCRA covered. According to the SEBI 2013 Notification, shareholders’ agreements and the articles of association of companies/body corporates may include options contracts for the purchase or sale of securities subject to the following:

1. The price or consideration payable for the purchase or sale of the underlying securities pursuant to the exercise of any option contained therein shall be in compliance with all laws for the time being in force as applicable.
2. The ownership and title of the underlying securities shall be held continuously by the selling party for a period minimum of one year from the date of entering into the contract. 
3. The actual delivery of the underlying securities shall settle the contract. The (FEMA) Foreign Exchange and Management Act, 1999 and its accompanying rules and regulations must also be complied with by these transactions.

Option clauses contracts are categorically excluded from the definition of “contracts in derivatives” according to the SEBI 2013 Notification’s supplementary explanation that section 18A of the SCRA, read with section 23(1)(d) of the SCRA, would not apply to contracts containing option clauses. According to section 18A of the SCRA, derivative contracts:

(i) That is traded on a recognised stock exchange or 

(ii) Are resolved on the clearing house of the recognised stock exchange in conformity with the regulations and bye-laws of the said stock exchange and are considered to be legal and valid.

The SEBI 2013 Notification stated in express terms that it did not have a retrospective effect. It provided that the notification would not affect or validate any contract entered into prior to the date of the notification. The SEBI 2013 Notification explicitly noted that it had no backwards-looking effects. It said that any contract signed before the notice date would not be impacted or validated by it.

Case Background

In an agreement dated December 8, 2007, Edelweiss and Percept Finserve entered into a share purchase agreement and agreed to buy 2,28,374 shares of Percept Ltd from Percept Finserve for a sum of INR 20 crores.

The SPA required Percept Limited and Percept Finserve to fulfil a number of conditions, including:

(a) the obligation to restructure the Percept Group by December 31, 2007, and to provide documents to Edelweiss as proof of completion; 

(b) not to dispose of any assets to third parties; and 

(c) the transfer of shareholding of all promoters of all affiliate/group companies to Percept Limited.

A dispute was raised by Edelweiss, who claimed that the SPA had been broken because the Restructuring was not complete. According to the argument, under the terms of the SPA, Edelweiss had the right to resell the shares to Percept Finserve for a price that would produce an internal rate of return (IRR) of 10% of the acquisition price.

As the remaining conditions were not met even by the extended deadline, Edelweiss executed its put option and sent a letter to Percept Finserve requesting that it put the Edelweiss put option into effect by January 12, 2009.

Due to Percept Finserve’s failure to honour the exercise of the Edelweiss Put Option, Edelweiss filed a claim in arbitration, claiming that Percept Finserve was obligated to repurchase the shares from Edelweiss at an IRR of 10% of the purchase consideration in the event that the SPA had been violated.

Arbitral award – The sole arbitrator determined that the SCRA did not permit the Edelweiss Put Option because (a) it was a forward contract, which was forbidden by Section 16 of the SCRA read with the March 2000 Notification; and (b) it was an option relating to the future purchase of shares that were not currently traded on a recognised stock exchange, which was prohibited by Section 18A of the SCRA.

Further, unsatisfied with the arbitral award, Edelweiss challenged the Arbitral award under Section 34 of the (Arbitration Act) Arbitration and Conciliation Act, 1996, and Bombay High Court’s single-judge bench set aside the arbitral award on the grounds that:

(a) the Edelweiss Put Option was not a contract for the sale or purchase of shares at a future date; 

(b) the contract would only come into existence upon Percept Finserve’s failure to perform the subsequent condition under the SPA and Edelweiss’ decision to exercise the put option;

(c) The Edelweiss Put Option was only a right, not an obligation, to resell the shares to Percept Finserve upon failure to perform the condition subsequently; 

(d) The contract cannot cease to be a spot delivery contract, which calls for actual delivery, merely because the original seller of the securities is given the option to complete the securities repurchase by a specific date.

Key Arguments

Edelweiss’s arguments contested that the arbitrator’s decision disagreed with the Bombay High Court’s ruling in the matter of MCX Stock Exchange LTD v. SEBI, generally known as the MCX Decision. Put option contracts cannot be categorised as forward contracts, according to the MCX decision, because the contract is formed the day the option is exercised. At that point, a spot delivery contract may be put into effect. As a result, Edelweiss contested the arbitrator’s decision that the put option clause was unlawful since it was a forward contract.

The put option, according to Edelweiss, did not meet the definition of a derivative contract under section 18-A of the Securities Contract Regulation Act (SCRA). Since the put option’s value was not derived from an underlying security or asset, Edelweiss claimed that it was not a derivative.

Furthermore, the put option could not be regarded as a derivative contract under section 18-A of the SCRA because it was a private contract between two persons and was not traded on a recognised stock exchange.

Given these defences, Edelweiss attempted to overturn the arbitrator’s ruling, arguing that the put option was not a forward or a derivatives contract and so was not unlawful.

Judgment

According to the Division Bench, a put option is not a forward contract. Upon the occurrence of an event or contingency and the subsequent exercise of the option by a party upon the happening of that event or contingency, the contract would, if at all, come into existence at a future point in time. As a result, Section 16 of the SCRA, read with the SEBI 2000 Notification, did not prohibit the put option.

The court evaluated the put option clause in light of SCRA Section 18-A. In accordance with the regulations and bylaws of such a stock exchange, “contracts in derivatives” must be:

1. Traded on a recognised stock exchange.
2. Settled on the clearing house of a recognised stock exchange.
3. Between the parties and on the terms that the central government may specify accordingly.

The court determined that instead of directly forbidding the formation of a call or put option, Section 18-A only controlled the trading or dealing in such options as securities.

The court made it clear that the SEBI 2013 Circular was not a protective notice but rather a prohibitory one that forbade any contracts other than those specifically named in it. The court further held that the SEBI 2013 Circular could not protect a contract if it were merely an options contract because it was never forbidden in the first place.

The court found that the arbitrator had erred in characterising the contract as a “contract in derivative” only because it featured a put option for stocks. As a result, the court quashed the arbitral award due to its illegality. The Bombay High Court’s earlier ruling in MCX Stock Exchange Ltd v. SEBI, which said that an “option” is in the form of a privilege and that its execution depends on the discretion of the person who has been granted it, was also cited by the Division Bench. 

The fact that such a put option clause was “never forbidden” means that they were acceptable even before the October 2013 Notification, which is significant. The appellants contended that the October 2013 Notification wording did not validate put option clauses if the underlying agreement was signed before the notification’s effective date. 

The Division Bench dismissed this contention and reaffirmed that put option clauses, such as the Edelweiss Put Option, will be enforceable under the SCRA’s scheme regardless of whether the underlying agreement is executed before or after the October 2013 Notification.

Conclusion

As a result, the Division Bench supported the learned Single Judge’s decision and declared the Edelweiss Put Option clause enforceable. The Division Bench has made it clear that even if the underlying agreement was signed before the date of the October 2013 Notification, the SCRA does not forbid put option clauses from being enforced. Despite being in place for a while, the dispute over spot delivery contracts has yet to be settled. However, recent changes made by Indian regulators since 2013 have given both domestic and foreign investors some relief. It is essential to carefully construct shareholder’s and investment agreements containing put options, assuring compliance with all relevant legislation.

Also Read: Enforceability of Options under FEMA