Almost all joint ventures, private equity and other investment arrangements provide for the various rights and obligations of each party. Common examples of such rights and obligations are “put options” and “call options”.
Essentially a put option means that the option holder has the right to require the other party, namely the option grantor, to buy shares/debentures held by the option holder on the occurrence of certain events and on the basis of pre-agreed pricing formulas. In other words, the option grantor has binding obligations to buy the shares/debentures “put” to him by the option holder.
Illustration: Jayachandran / Mint
Conversely, a call option gives the option holder a right to “call” on the option grantor to sell the shares/debentures held by the option grantor to the option holder on the occurrence of certain events and again on the basis of pre-agreed pricing formulas. The option grantor has a binding obligation to sell his shares/debentures to the option holder on a “call” from the option holder.
In most likely circumstances, the price for the shares/debentures is not agreed upon. But what is agreed between the parties is the pricing formulas or the basis of calculation of the exercise price of the option (usually the formula is based on fair market value, discounted future cash flows or other standard industry benchmarks). In addition, the put and call options can be securitized, with the option grantor providing appropriate security for the underlying options. Put options are also viewed as providing exit routes to the investor under circumstances where the promoters failed to achieve other exit routes for an investor, such as public listing of the investee company through an initial public offering. Call options, among other measures, are also used by an investor to increase his stake in a company and get the benefit of pre-agreed pricing formulas.
For example, if a company’s share price significantly increases, it would be a profitable move for an investor to exercise his call option and purchase shares at a lower valuation, as determined by the agreed pricing formula.
Put and call options have also emerged as pre-eminent tools in the event there is a default under an investment agreement, which dictates a transaction. For example, the non-defaulting party may be given the right to “put” its shares to the defaulting party at a price which is above the fair market value of the securities concerned; alternatively, the non-defaulting party may be given the right to call upon the defaulting party to purchase the shares of the defaulting party at a price which is below the fair market value of the securities concerned. Essentially, the right to put or call can be exercised by the non-defaulting party at his discretion, considering the market conditions and financial capabilities of the defaulting party.
A legal challenge for exercising put and call options is the statutory pricing norms applicable to a non-resident in respect of the purchase or sale of shares to an Indian resident partner. If a non-resident investor seeks, under a put option exercised by it, to sell shares to an Indian resident, the sale price cannot exceed the fair value of shares determined under the pricing guidelines under applicable foreign exchange regulations. At the same time, if a non-resident investor seeks, under a call option exercised by it, to buy shares from the Indian resident shareholder, the purchase price cannot be below the fair value of shares determined under the pricing guidelines under applicable foreign exchange regulations.
The above two examples will also apply if the Indian resident seeks similar rights on the non-resident. The parties, nevertheless, can explore approaching the Reserve Bank of India for specific approval for any transaction that they propose to conduct which is not in accordance with the pricing guidelines, if they have a strong case for it.
Another legal challenge for put and call options is the applicability of the Securities Contract (Regulation) Act, 1956 (SCRA) to put/call options for an unlisted public company. SCRA purports to prohibit derivative or forward trading contracts except when made on a “spot delivery basis”. While one view is that put or call options may fall within the ambit of SCRA, others take the view that if the actual sale/purchase is being made on a spot delivery basis, the put/call options are merely agreements to sell/purchase shares and, therefore, are outside the purview of SCRA.
The debate is limited to unlisted public companies owing to conflicting judgements on this issue. SCRA is not applicable to a private limited company and separate regulations govern agreements for the sale and purchase of listed company shares (such as takeover regulations).
Then there is the open issue of specific performance of the put/call options, that is, whether a party can be obligated under law to perform its obligation under a put or a call option.
In this respect, there is a significant lack of judicial precedents. Considering the downturn the economy is witnessing (leading to restructuring of investments and, in some cases, disputes/terminations of the joint ventures), it is expected that this issue, too, will soon reach the courts, resulting in some conclusive analysis of this issue.
This column is contributed by Hardeep Sachdeva of AZB & Partners, Advocates & Solicitors.
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