The Securities and Exchange board of India (SEBI) recently issued a notification bringing changes to the Securities Contracts (Regulation) Act (SCRA). The said notification has provided more flexibility to enter into merger and acquisition (M&A) deals, by allowing entities to include preferential clauses like “right of first refusal, tag-along and dragalong” in their share purchase agreements.
The Right of Refusal gives one of the parties in an M&A deal the first option to buy out its partner in the event of the latter wishing to exit from the agreement at a later stage. Tag-along and drag-along clauses allow one of the partners to join the other party in cases like further acquisition or sell out deals. Such options in shareholder agreements give the investor an option to either sell the shares (put option), or to buy additional shares (call option) at a future date.
These pre-emptive rights and call-put options are common arrangement between parties/investors in joint ventures, private equity and venture capital. Until now, there was uncertainty on the enforceability of such pre-emptive rights and call and put options as the SEBI had earlier ruled that inclusion of these rights did not confirm to the SCRA Act.
There has always been confusion on the kinds and the type of contracts that can be entered into with respect to ‘marketable securities’ under the SCRA. The SEBI had issued a notification in 2000, pursuant to which it prohibited all contracts, except spot delivery contracts or contracts for cash or delivery or contract in derivatives, in territories to which the SCRA applied.
Section 16 of the SCRA empowers the central government to declare by notification that no person may enter into any contract for the sale or purchase of any security specified in that notification to prevent speculation. But Section 28 (2) empowers the central government, by notification, to specify any class of contracts to which the SCRA shall not apply. It can do this in the interests of the economic development of the country. Section 29A of the SCRA further empowers the central government, by a notification, to delegate powers to SEBI or the Reserve Bank of India.
The central government had delegated such power under Section 16 of the SCRA to SEBI. Further, it had issued another notification distributing the power among SEBI and RBI .In this background, the validity of the pre-emptive rights, the dragalong and tag-along rights, call and put options was always questionable. This issue has been the subject matter of a number of cases as SEBI had limited the scope of permissible contracts to spot contracts and derivative contracts.
These provisions have been relaxed after the notification of 2013 as the amendments have had prospective effect. These changes would not affect any contract which has been entered into prior to the date of this notification.
Earlier, these contracts required the approval of SEBI, a factor which has now been done away with. The new notification specifically provides that the aforesaid permissible contracts shall be in accordance with the provisions of the Foreign Exchange Management Act, 1999, and the rules and regulations made there under.
Prior to the current notification, confusion prevailed regarding the validity of options. Two views existed on the matter. One, that the contracts are not valid since they were neither spot-delivery contracts nor were they derivatives that traded in stock exchanges. The other view was that the options were mere rights with the option holder, and did not constitute a completed contract. They were seen as merely an agreement to contract at a future time, and hence at the time of entering into the option, no forward contract was entered into. By including contracts for purchase or sale of securities pursuant to exercise of an option, SEBI has put to rest a long-standing debate.
By putting a time period of one year of holding and a clause for actual delivery of the underlying securities, the intention is to prevent any speculative transactions among the parties which was the intent behind the introduction of SCRA as well.
The clause of prospective application may be seen as implying that such contracts before the notification might not have been valid. To such extent, the legal enforceability of such contracts might still be questionable, and hence encourage parties to re-enter into the already existing contracts.
The SEBI has also permitted options in shareholders’ agreements, subject to the extant exchange control regulations while the RBI may need to issue a notification permitting options in shareholders’ agreements to ensure cross-border deals may not be questioned.
These changes are likely to help boost the interest of foreign investors who tend to prefer such clauses in their deals. The demand for allowing such clauses was gaining ground for quite some time as foreign investors had to face regulatory hurdles. Inclusion of these provisions would help in removing ambiguity and attracting investors, especially overseas entities, many of which insist on such clauses while exiting at a later stage. While the validity of options and pre-emptive rights have now been settled, the notification seems to have added some more confusion with respect to the enforcement of option contracts. These contracts would not fall under the two preceding clauses, i.e. spot delivery contracts, or derivative contracts. Here is a brief explanation regarding the same:
It is pertinent to note that as per the provisions of the new Companies Act, 2013 (made effective from September 12, 2013), any contract or arrangement between two or more persons in respect of transfer of securities of public company shall be an enforceable contract. The SEBI relaxation and aforesaid Company Law amendment which expressly allow contractual restriction on transfer of public company shares will facilitate pre- emptive rights on public company shares with greater certainty on enforceability. The proposed changes permitting options are laudable and meet the long-standing industry demand to allow such arrangements. After these changes to company and securities laws, greater clarity/certainty from an Indian exchange control standpoint on such arrangements, particularly on options, will be welcomed by non-residents
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