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”).
While Section 20 was omitted in 1995 (“1995 Amendment”) from the standpoint of permitting put option clauses, the 1969 Notification continued to be in force. 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 (“March 2000 Notification”). As the March 2000 Notification was not happily worded, the ambiguity surrounding the enforceability of put/ call option clauses continued.
The 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.
Subsequently, to clarify the legal position, SEBI issued a notification on October 3, 2013, which rescinded the March 2000 Notification, and for the first time, permitted contracts in shareholders agreements or provisions in the articles of association, providing for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:
- 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;
- the contract is settled by way of actual delivery of the underlying securities;
- the contract is in compliance with FEMA.
Along with the October 2013 Notification, SEBI also issued a Press Release stating that the said notification permits put/ call options, subject to compliance with the stipulated conditions.
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”.
In this backdrop, the latest judgment of a Division Bench of the Bombay High Court (“Bombay HC”), in Percept Finserve Private Limited v. Edelweiss Financial Services Limited(“Percept Finserve Judgment”) assumes relevance, as the Bombay HC has upheld the enforceability of a put option clause in a share purchase agreement (“SPA”), that was executed prior to the October 2013 Notification.
Edelweiss and Percept Finserve entered into a SPA dated December 8, 2007, 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 – (a) an obligation to restructure the Percept Group by December 31, 2007, and provide documents to Edelweiss as proof of completion of the same; (b) not to dispose off any assets to third parties; and (c) transfer of shareholding of all promoters of all affiliate/ group companies to Percept Limited (“Restructuring”).
Edelweiss raised a dispute alleging that the Restructuring had not been completed, resulting in breach of the SPA. It was contended that as per the SPA, in the event of a breach, 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”).
Subsequently, Edelweiss extended the timeline for execution of the obligations to June 30, 2008, and also entered into an amendment agreement, that inter alia provided that in the event of non-fulfilment of the condition subsequent within the extended timeline, Edelweiss shall continue to be entitled to exercise the Edelweiss Put Option.
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 – and that Percept Finserve was bound to re-purchase the shares from Edelweiss, at an IRR of 10% of the purchase consideration.
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.
A Single Judge Bench of the Bombay HC set aside the arbitral award under Section 34 of the Arbitration and Conciliation Act, 1996 (“Arbitration Act”), inter alia on the grounds that – (a) the Edelweiss Put Option was not a contract for sale/ purchase of shares at a future date; (b) the contract would come into being only upon failure of Percept Finserve to perform the condition subsequent under the SPA, and Edelweiss in turn deciding to invoke the put option; (c) as the Edelweiss Put Option was only a right, but not an obligation, to re-sell the shares to Percept Finserve upon non-performance of the condition subsequent, this cannot be considered as a ‘forward contract’; and (d) merely because the original seller of securities is given an option to complete repurchase of securities by a particular date, it cannot be said that the contract ceases to be a spot delivery contract i.e. a contract which provides for actual delivery of securities and the payment of the purchase price either on the same day as the date of the contract or on the next day.
The Percept Finserve Judgment
The Division Bench agreed with the reasoning adopted by the learned Single Judge on all counts, and 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.
It was accordingly held that a contract for re-purchase of shares by Percept Finserve came into being only upon exercise of the Edelweiss Put Option, in light of non-fulfilment of the condition subsequent.
Further, it was held that the Edelweiss Put Option was not prohibited under Section 18A of the SCRA read with the March 2000 Notification, and such a put option clause could not be considered as a contract in derivatives. According to the Division Bench, the law does not prohibit a put/call option, it only prohibits the trading or dealing in such option treating it as a security.
Significantly, it was held that such a put option clause was “never prohibited” – to denote that put option clauses were permissible even prior to the October 2013 Notification. Based on the wording of the October 2013 Notification, the appellants had argued that the said notification does not validate put option clauses where the underlying agreement was executed prior to the date of the October 2013 Notification. This argument was rejected by the Division Bench, which reiterated that put option clauses like the Edelweiss Put Option will be enforceable under the scheme of the SCRA, irrespective of whether the underlying agreement is executed prior to, or post the October 2013 Notification.
The Division Bench accordingly upheld the judgment of the learned Single Judge, and held that the Edelweiss Put Option was enforceable.
The Percept Finserve Judgment has two key takeaways.
First, the Division Bench has clarified that the SCRA does not prohibit enforceability of put option clauses, even if the underlying agreement was executed prior to the date of the October 2013 Notification. Hence, going forward, parties cannot resist giving effect to a put option clause, on the specific ground that the underlying agreement was entered into prior to the October 2013 Notification.
In the authors’ view, this interpretation is correct, as the October 2013 Notification only clarified the prevailing legal position after Section 20 of the SCRA (that prohibited options in securities) was deleted by the 1995 Amendment, and the said notification imposes certain conditions that have to be fulfilled for exercise of the put/ call option. Along with imposing specific conditions for exercise of the put/ call option, the October 2013 Notification only sought to remove the ambiguity that arose by virtue of the March 2000 Notification.
The embargo on enforceability of put options had already been lifted by virtue of the 1995 Amendment, the Statement of Objects & Reasons of which specifically notes that the bill seeks to “facilitate the issuance and trading of options in securities”.
Post the 1995 Amendment, the SCRA was never an obstacle to enforceability of put options, by resident as well as non-resident investors. For non-residents, what has always acted as a hindrance is the FEMA pricing guidelines, which provide that in case of sale of shares by a non-resident to a resident, the sale price cannot exceed the fair value of the shares, at the time of exit.
The RBI has consistently maintained a policy of not permitting non-residents from getting any guaranteed exit price upon exercise of the put option, and has always insisted that the exit price should be benchmarked to the fair value of the shares, at the time of exit.
The Percept Finserve Judgment accordingly reiterates that a put option can be enforced as long as the conditions prescribed under the October 2013 Notification (which specifically provides for compliance with FEMA) are fulfilled.
Second, as the Division Bench has upheld the judgment of the learned Single Judge that set aside the arbitral award under Section 34 of the Arbitration Act, the Bombay HC has clearly recognised that if an arbitral tribunal incorrectly refuses to give effect to a put option clause on the mere ground that such options are prohibited under the SCRA, then this may give rise to sufficient grounds for setting aside the arbitral award under Section 34 – as such an arbitral award would be patently illegal, although we have to bear in mind that the challenge to the arbitral award in this case was filed prior to the 2015 amendments.
Nevertheless, the Percept Finserve Judgment assumes significance as it finally clarifies, beyond doubt, the legal position with respect to enforceability of put option clauses of the SHA, under the scheme of the SCRA.
 Section 20(1) of the SCRA had provided that – “Notwithstanding anything contained in this Act or in any other law for the time being in force, all options in securities entered into after the commencement of this Act shall be illegal”.
 Notification No. S.O. 2561, dated June 27, 1969, titled ‘Restriction on Enter into Contract for Sale or Purchase of Securities’, issued by the Ministry of Finance, Government of India.
 Section 20 was omitted by the Securities Laws (Amendment) Act, 1995.
 SEBI Notification bearing reference no. S.O. 184(E), dated March 1, 2000.
 Securities Laws (Amendment) Act, 1999.
 SEBI Notification bearing reference number No. LAD-NRO/GN/2013-14/26/6667, dated October 3, 2013.
 Foreign Exchange Management Act, 1999.
 SEBI Press Release dated October 3, 2013, bearing reference no. 98/ 2013. The Press Release also notes that the October 2013 Notification is also in line with the proviso to Section 58(2) of the Companies Act, 2013, which states as follows – “Providedthat any contract or arrangement between two or more persons in respect of transfer of securities shall be enforceable as a contract”.
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 Percept Finserve Private Limited is referred to as “Percept Finserve” and Edelweiss Financial Services Limited is referred to as “Edelweiss”.
 The amendment agreement was entered into on April 23, 2008.
 Section 2(i) of the SCRA provides that “spot delivery contract” means a contract which provides for— (a) actual delivery of securities and the payment of a price therefor either on the same day as the date of the contract or on the next day, the actual period taken for the despatch of the securities or the remittance of money therefor through the post being excluded from the computation of the period aforesaid if the parties to the contract do not reside in the same town or locality; (b) transfer of the securities by the depository from the account of a beneficial owner to the account of another beneficial owner when such securities are dealt with by a depository;
 For a detailed analysis of the interplay between the enforceability of put option clauses and the FEMA pricing guidelines, interested readers may refer to the two-part series published on the CAM Blog, available at the following links – (a) Part I – Legislative gap between the Arbitration Act and FEMA: Should Parliament step in? – Part I | India Corporate Law (cyrilamarchandblogs.com); (b) Part II – Legislative gap between the Arbitration Act and FEMA: Should Parliament step in? – Part II | India Corporate Law (cyrilamarchandblogs.com)