Why put off investors' privileged options?

Investors' privileged options have certainly drawn limelight recently. A few weeks back, the informal guidance of SEBI on put/buy-back option steered the debate on privileged contracts of shareholders. The recent update in Foreign Direct Investment (FDI) policy (2011), has given another perspective to the debate on investors' privileged options.

This article captures various statutory provisions dealing with the investor's privileged options.

Free transferability of shares

Though Companies Act, 1956 does not specifically restrict private arrangements inter-se shareholders, however, such arrangements have been questioned at times on the grounds of ‘free transferability' of shares under the provisions of Section 111A read with Section 82 of the Companies Act.

The Supreme Court in the case of VB Rangaraj (1992) held that shares of a company are ‘freely transferable' and any restriction imposed through a private arrangement is unenforceable unless incorporated in the Articles of the company.

The Gujarat high court in the case of Mafatlal Industries (1997) followed the ratio drawn in the VB Rangaraj's case in relation to a public limited company (VB Rangaraj's case dealt with private limited company).

Later, a contrary view was taken by the Bombay High Court in the case of Bajaj Auto (February 2010) wherein the court held that a general right of pre-emption in relation to the shares of public limited company is inconsistent with the Section 111A of the Companies Act and not valid.

However, it is interesting to note that the Bombay High Court in another case of Messer Holding (Sep 2010) ruled that a private arrangement between shareholders is enforceable unless specifically barred by the articles of the company.

In this backdrop, arguably a view can be taken that private arrangements between shareholders conferring privileged rights such as right of first refusal are not inconsistent with the provisions of Companies Act, if such rights are incorporated under the articles of the company; though the positions remains litigious.

Derivatives

From capital market regulations perspective, the debate on whether call/put option arrangement be allowed under private arrangement, got a push when SEBI in its informal guidance in the case of Vulcan Enterprise (2011) directed the parties to drop the call/put option from their share transfer arrangement.

In 2000, the Securities Contracts (Regulation) Act, 1956 (SCRA) was amended including provision for ‘contracts in derivative', in terms of which derivative contracts are valid only if such contracts are traded on recognised stock exchange and settled on the clearing houses of the recognised stock exchange.

SEBI is of the view that a valid call/put option should be traded on recognised stock exchanges. As per the aforesaid SEBI's informal guidance, since the call/put option to buy back shares would be exercised in a future date (say 2-3 years later), such transactions do not qualify as ‘spot delivery' under the SCRA and become derivative transactions, which are not considered valid under SCRA.

However, there is a very old circular of 1961, issued under Section 28 of SCRA permitting privileged contracts between shareholders in joint ventures etc., which perhaps is not taken cognizance of.

Equity Instruments with

inbuilt options

In terms of the recently updated FDI policy, equity instruments which have inbuilt options would not henceforth be considered as FDI but as ECB. Though privileged options are in private domain of shareholders, yet the company may suffer undue hardship of following ECB norms in terms of end-use restrictions etc.

Earlier in April 2007, the Government issued a press note in relation to Optionally Convertible Preference Shares (OCPSs) considering OCPSs as ECB. Such bold move by the Government was with an intention to control large debt flowing into country in form of capital.

Accordingly, in order to avoid hardship of ECB norms, foreign investors often used FDI compliant instruments such as compulsorily convertible preference shares along with say, put options. The latest revision in FDI policy with the new condition would curb such equity instruments.

The capital market regulator views shareholders privileged options from the perspective of legitimacy of such contracts in the backdrop of specific provisions of SCRA.

This is more of a technical aspect as compared to the one relating to the latest FDI change, which is a policy matter. Of course, the age-old corporate law controversy on such privileged options from the perspective of ‘free transferability' of shares adds to the ambiguity and debate.

Though the intention is to promote long term FDI in India, but restricting any in-built option might hamper FDI inflows to the country. The regulators may provide for some checks and balances rather than curbing any in built option straight away.

(The author is Executive Director, PwC India.)

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