Are Option an Option

7/28/2019 Are Option an Option

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The imp ortance of options

In the last two decades, India has recorded impressive economic growth buoyed bystrong corporate performance. To sustain such growth it is important for companies to havesufficient resources. Fund raising is, therefore, integral to sustained corporate growth.

Financial or strategic investment is a vital component of fund mobilisation by companies.Both financial and strategic investors have an investment horizon for maximising returns oninvestment. To meet these requirements such investment normally has an exit mechanismbuilt into the investment documentation. The most common exit mechanism is achievementof an IPO within a certain period followed by an option to divest if the IPO is not done. Thisoption to divest is, therefore, critical to an investor.

The India growth story has also been sustained by burgeoning foreign exchange inflows. A vehicle for such inflows is a joint venture which combines local expertise with internationalknow-how. In joint venture relationships, there is often an option with one of the partners tobuy the shares of, or sell shares, to the other partner on the occurrence of an event. Options

are, therefore, important structuring tools to mobilise investment and build partnerships.Unfortunately, the enforceability of options has been questioned as a result of legislation and judicial precedent. This article seeks to investigate whether options remain an option for structuring commercial deals.

What is an optio n?

A good starting point is to describe an option. An option gives the option-holder the rightto either buy a specified number of shares of, or sell a specified number of shares to, theoption provider at a specified price on the occurrence of an event. If the option-holder hasthe right to buy shares from the option provider it is termed as call option. If the option-holder has the right to sell shares to the option provider it is termed put option.

An option contract is a contingent contract2 which gives the option-holder the right to buyor sell shares on the occurrence of an event. The contract therefore is in force whenexecuted but becomes effective only when the event has occurred. The option provider isonly bound when the option is exercised. In sum, two things must happen for the optionprovider to be bound (i ) the event for exercise of the option must have occurred; (ii ) theoption must be exercised by the option-holder after (i ). Similarly, the option-holder is onlybound when he exercises the option. There is no obligation on the option-holder to purchaseshares until such exercise.

Why is an option contract con sidered unenforceable?

For a public company:

i an option contract, it is argued, is not a spot delivery contract and hence violates therequirements of the Securities Contracts (Regulation) Act, 1956 (SCRA).

ii a call option is considered unenforceable since it amounts to a restriction on transfer of shares.

It must be reiterated that the above arguments apply only in relation to shares of a publiccompany, whether listed or not, and not to a private company. The genesis of thesearguments is elaborated below:

Argument 1 − SCRA

SCRA was enacted to prevent undesirable transactions in securities by regulating the

business of dealing therein. SCRA achieves this end by creating a market for securities(stock exchanges) and regulating contracts in securities.



A contract is defined as a contract for or relating to the purchase or sale of securities3.Securities include inter alia shares, scrips, stocks, bonds, debentures, debenture stockor other marketable securities of a like nature in or of any incorporated company or other body corporate4. Option in securities is a contract for the purchase or sale of a right to buy or sell or a right to buy and sell securities in future and include a put, a call or a put and call insecurities5. A spot delivery contract provides for (i ) actual delivery of securities and paymentof price therefor either on the same day as the date of the contract or the next day; or ( ii )transfer of securities through a depository6.

Under Section 16 of SCRA, to prevent undesirable speculation in securities the CentralGovernment may declare by notification that no person in the notified area shall enter intospecified contracts for sale or purchase of security except with the permission of the CentralGovernment. In June 1969, the Central Government issued a Notification7 (the 1969Notification) under Section 16 of SCRA, which applied to the whole of India, prohibiting allcontracts for sale or purchase of securities other than spot delivery contracts or contracts for cash or hand delivery or special delivery. This notification was rescinded on 1-3-2000 andthe power to regulate contracts in securities demarcated between the Securities Exchange

Board of India (SEBI) and Reserve Bank of India (RBI). Both SEBI and RBI issuedNotifications on the same day, 1-3-20008which had the same effect as the 1969 Notification.

Section 20 of SCRA which provided that options in securities were illegal after thecommencement of SCRA, was deleted by the Securities Laws (Amendment) Act, 1995.

Under Section 28(2) of SCRA, the Central Government may, in the interest of trade andcommerce or economic development, specify any class of contracts to which SCRA doesnot apply by notification in the Official Gazette. In June 19619 the Central Governmentspecified contracts for pre-emption or similar rights contained in the promotion or collaboration agreements or in the articles of association of limited companies as contractsto which SCRA would not apply (the 1961 Notification). It is unclear whether this notification

would apply to option contracts. Even though option contracts form part of the same basketof rights as contracts for pre-emption in collaboration agreements, since Section 20 of SCRAwas still in force at the time of the 1961 Notification, it may be more appropriate to concludethat option contracts were excluded.

In addition to the above provisions, it is important to note that based on the use of thephrase “other marketable securities of a like nature” in the definition of securities, SCRA hasbeen held to apply only to public companies, whether listed or not, and not privatecompanies. In this regard, marketable has been interpreted to mean “capable of beinglisted”. Therefore, applying the doctrine of ejusdem generis to the definition of securities,SCRA would only apply to marketable securities or those securities that are listed or capableof being listed. Hence, SCRA only applies to securities of a public company 10.

The argument against option contracts in relation to shares of a public company issimple. Such contracts provide for the purchase or sale of securities, in future, at a specifiedprice. Since the actual delivery of securities and payment of price do not take place on thedate of the contract or the next day, such option contracts are not spot delivery contracts.Hence, option contracts require the consent of SEBI or RBI, as the case may be, under theNotifications issued on 1-3-2000. If such consent is not obtained, the parties to the optioncontract would violate the provisions of SCRA and be liable to fine of up to Rs 25 croresand/or imprisonment of up to 10 years11. This argument finds support in the judgment of theBombay High Court in Niskalp Investments and Trading Co. Ltd. v. Hinduja TMT Ltd.12 The judgment was delivered by Kamdar, J. in a summons for judgment pursuant to a summary

suit. In this case the plaintiffs and defendants were shareholders of a company. The plaintiffshad a put option to sell their shares to the defendants at a specified price if the company



failed to list its shares before a certain date. After the company failed to list, the put optionwas exercised by the plaintiffs but not honoured by the defendants.

The plaintiffs filed a summary suit for recovery of money from the defendants under theput option. The plaintiffs argued for the validity of the put option contract relying on theDivision Bench judgment of the Bombay High Court in Jethalal C. Thakkar v. R.N.Kapur 13 where it was held that since the contract was contingent it would not fall foul of provisions of the Bombay Securities Contracts Control Act, 1925 requiring ready deliverycontracts14. This argument was rejected by Justice Kamdar on the ground that the Bombay Act was not pari materia to the SCRA. He relied on the reasoning given in an earlier judgment of Rebello, J.15 to hold that since the put option was not a spot delivery contract itviolated SCRA and could not be enforced16. On this ground, the Court granted thedefendants unconditional leave to defend while transferring the suit to the list of commercialcauses.

Argument 2 − Restrictions on Transfer

Section 111-A of the Companies Act, 1956 (the Act) provides that the shares or

debentures and any interest therein of a public company shall be freely transferable.Therefore, a public company cannot impose any restrictions on the transfer of its shares.

In the oft-quoted V.B. Rangaraj v. V.B. Gopalakrishnan17 the Supreme Court held thatrestrictions on transfer of shares not contained in the articles of association of a companywould not bind the company or the shareholders. Although this case involved shares of aprivate company, the reasoning of the Court has been applied to all companies. The Courtrelied on Section 82 of the Act which provides that shares are movable property transferablein the manner provided by the articles of a company and other provisions of the Act, toobserve, “Whether under the Companies Act or Transfer of Property Act, the shares are,therefore, transferable like any other movable property. The only restriction on the transfer of the shares of a company is as laid down in its articles, if any. A restriction which is not

specified in the articles is, therefore, not binding either on the company or on theshareholders. The vendee of the shares cannot be denied the registration of the sharespurchased by him on a ground other than that stated in the articles.”18

In Pushpa Katoch v. Manu Maharani Hotels Ltd.19 a memorandum of family agreementhad been entered into by the appellant and the respondents which gave each party a pre-emptive right to purchase shares of the other parties in a public company. This pre-emptiveright was not contained in the articles of the company. The respondents sought to transfer their shares in violation of the memorandum of family agreement. On an appeal from theCompany Law Board which ruled in favour of the respondents, the Delhi High Court held: ( i )relying on Rangaraj 20, restrictions on transfer must be included in the articles of a company

to bind the company and the shareholders; (ii ) the pre-emptive right was not included in thearticles of the company; (iii ) even if the pre-emptive right was included in the articles it wouldbe unenforceable since it would violate Section 111-A of the Act and be ultra vires21.

Although the above position seems clear-cut, some confusion has been caused by theSupreme Court decision in M.S. Madhusoodhanan v. Kerala Kaumudi (P) Ltd.22, where itwas held that an agreement to transfer shares not contained in the articles of a privatecompany could be specifically enforced since it did not amount to a restriction on transfer.

A call option, it is argued, acts as a fetter on the option provider's ability to transfer thoseshares of a company that form part of the option. Therefore, applying the above principles,the call option can only be enforced if it is included in the articles of the company. Pushpa

Katoch23 read with Sections 9 and 111-A of the Act and Section 23 of the Contract Act, 1872makes it clear that restrictions on transfer of such shares in an agreement or the articles of a



public company would be ultra vires the Act and for an unlawful object. Therefore, a calloption cannot be enforced if it relates to shares of a public company.

Analysis − Are options an option?

Despite the arguments set out above, I would like to argue in favour of the legal validity

of options. Options are important for structuring investment deals. On a broad policy level,options do not lead to undesirable speculation in securities but merely provide avenues for disinvestment or buyouts. Hence, the stated approach of courts to uphold, to the extentpossible, commercial arrangements between consenting parties must be relied on.

Do option contracts violate SCRA and the Notifications issued thereunder? To answer this question, it is important to emphasise that Section 20 of SCRA which prohibited optioncontracts has been deleted. Further, the 1961 Notification shows intent to uphold rights incollaboration agreements in the interests of trade, commerce and economic development.The 1961 Notification followed by the repeal of Section 20 shows legislative intent that optioncontracts should be valid.

Further, is an option contract a contract relating to the sale or purchase of securities? Isubmit that it is not. As discussed above, an option contract is a contingent contract.Therefore, when it is executed the contract comes into force but it becomes effective only onthe occurrence of a contingency, which could be the lapse of time or the occurrence or non-occurrence of an event within a specified period. Further, the option must be exercisedbefore the option provider is bound. Consequently, until the occurrence of the contingencyand exercise of the option, the option provider is under no binding obligation to purchase or sell securities. He has only agreed to a future obligation and it is far from certain whether such obligation will crystallise or not. In the circumstances, the contract relating to sale or purchase of securities takes effect only when the option is exercised. This is very similar to afloating charge which floats over an asset pool of a company until the occurrence of an eventwhich converts it to a fixed charge. Once the option is exercised, the contract comes into

being and must be completed on a spot-delivery basis. Hence, till the option is exercised theoption contract is nothing more than a commitment and should not fall foul of the spotdelivery requirements under the SCRA.

In support of my argument, I would like to quote Chief Justice Chagla's observationsin Jethalal C. Thakkar case24 : “It is clear on a plain reading of this contract that no obligationattached with regard to the purchase of these shares on the part of the defendant until thecontingency contemplated occurred after the lapse of 12 months. A clear distinction must beborne in mind between a case where there is a present obligation under a contract and theperformance is postponed to a later date, and in a case where there is no present obligationat all and the obligation arises by reason of some condition being complied with or some

contingency occurring. The contract before us falls into the second category. At the datewhen the contract was entered into there was no present obligation with regard to thepurchase or sale of shares. It was definitely not a case where a present obligation havingbeen created the parties agreed to postpone performance. The parties intended and madetheir intention clear by the language of the contract itself that there was no obligation uponthe defendant to purchase these shares until the contingency contemplated took place…The obligation undertaken by the parties was only in the realm of potentiality. There wasno certainty that the potentiality would become an actuality …”25

Also noteworthy are the views of Mr Cyril Shroff and Mr V Umakanth in their article “TheFuture of Options”26, “The provisions of the SCRA govern „contracts‟ relating to purchase or sale of securities. The issue as to whether the grant of a mere option amounts to a „contract‟

merits consideration. It is arguable that an option may be treated as not being a completedcontract (that is, being in a nature of a contingent contract) and that such contract would



come into effect only upon the exercise of the option. It would result in a contract for sale or purchase of securities only upon exercise of the option and not merely upon the grantthereof. In such case, once it becomes a contract (that is, upon the exercise of the option),the parties could ensure that the consideration is paid and the securities delivered either onthe same day or the next day so as to bring it within the purview of a „spot delivery contract‟,which is permissible under the SCRA. However, there has been no definitive ruling from anycourt or regulatory authority in this behalf.”

The authors go on to state: “This seems to be a classic case of an age-old legislation (suchas the SCRA) being implemented in the present era, without any alterations being made tocater to emerging market needs. Although there has been progress in the Indian markets,such as the introduction of derivatives, the approach has only been piecemeal. Can onereconcile the fact that while derivatives (such as options) can now be legally traded on thestock exchange, the legal regime does not seem to permit the creation of such optionsthemselves in the first place? Since SEBI possesses delegated powers under Section 16 of the SCRA, it is imperative that sufficient thought is given by it to the matter and requisitemodifications are made to the legal regulations, such that genuine commercial transactionswhich do not involve any speculation are not affected by a legislation which is designed to

control market manipulation. Although issues such as this have already been considered bythe committee appointed by SEBI under the chairmanship of Justice Dhanuka whichrecommended a new securities legislation, these recommendations are yet to see the light of day.”

In the light of the above, I believe that Niskalp27 judgment suffers from a lack of clear reasoning and should not be considered definitive. This is buttressed by the fact that thisorder was in a summons for judgment where the Court's sole purpose is to determinewhether to provide the defendant unconditional leave to defend and deny summary relief.Therefore, this is not a decision on merits. Relying on another summons for judgment andtechnical distinctions between SCRA and the Bombay Securities Contract Control Act tooverride the sound reasoning of the Division Bench judgment in Jethalal C. Thakkar 28 further

diminishes the value of this order. In sum, based on the legislative intent of repealing Section20, SCRA and the contingent nature of option contracts, I believe that option contracts donot violate SCRA.

The next issue is whether call options are invalid as a restriction on transfer of shares.To reiterate, a call option gives the option-holder the right to buy specified shares of theoption provider at a specified price on the occurrence of a specified event. Like any other option, a call option does not crystallise until the option-holder validly exercises his option.This begs the question, is the option provider prevented from transferring his shares till thecall option is exercised? Practically, this may be the case but, unless the contract specificallyrestricts transferability, there is no legal bar to transfer. Therefore, absent specific restrictionsin the contract, it is possible for an option provider to deal in his shares until the call option isexercised, provided he is in a position to sell the number of shares constituting the calloption to the option-holder when he exercises the option. Consequently, the call option per se does not constitute a restriction on transfer of shares. If the call option is coupled with arestriction on transfer of shares, it may fall foul of Section 111-A of the Act read with Section9 of the Act as held in Pushpa Katoch29. But without such restriction, the call option is valid.

A related question is whether the option-holder would have sufficient remedy if the optionprovider was unable to transfer shares to the option-holder after he exercised the call option.I believe the option-holder would have a strong case for damages and may be in a positionto argue for specific performance. Under Section 10 of the Specific Relief Act, 1963 acontract for transfer of movable property (including shares) may be specifically enforced if

the property is not readily obtainable in the market. Shares of a private company and anunlisted public company are not readily available in the market (read stock exchange). An



option contract once effective is a contract for transfer of shares. Therefore if the shares areof an unlisted public company, the option-holder may be in a position to specifically enforcethe contract. For a listed public company, damages would be the only remedy30. Hence, anoption-holder appears adequately protected if a call option is interpreted as not imposing afetter on transfer of shares.

Conclus ion

To conclude:

i Options are vital to commercial arrangements between investors/shareholders/jointventure partners. Courts should facilitate such arrangements to encourage economicgrowth.

ii Options do not lead to undesirable speculation in securities. This is clear from thedeletion of Section 20, SCRA in 1995.

iii Options are contingent contracts which take effect on the occurrence of a contingency.Therefore, the spot delivery requirements arise only when the option is exercisedafter the contingency has occurred. Options do not violate SCRA.

iv A call option is not by itself a restriction on transfer of shares.v Therefore, options are and will remain an option both for private and public companies.

———

1 Senior Associate, Khaitan & Co., Mumbai. The views expressed in this article are solelythose of the author and do not necessarily reflect the views of Khaitan & Co. The author

would like to thank Mr Ravi Kulkarni, Mr Haigreve Khaitan, Mr Rabindra Jhunjhunwala, Mr

Bhavik Narsana and Mr Minhaz Lokhandwala for their help and support.

2 Please see, Sections 31-36 of the Contract Act, 1872 which deal with contingent contracts.

3 Section 2(a) of SCRA.

4 Section 2(h) of SCRA.

5 Section 2(d ) of SCRA.

6 Section 2(i) of SCRA.

7 No. S.O. 2561 dated 27-6-1969.

8 No. S.O. 184(E) and No. S.O. 185(E).

9 No. S.O. 1490 dated 27-6-1961.

10 Please see, Norman J. Hamilton v. Umedbhai S. Patel , (1979) 49 Comp Cas 1 (Bom) (para

17 onwards) (Sujatha Manohar, J.).

11 Section 23 of SCRA.

12 (2008) 143 Comp Cas 204 (Bom) (S.U. Kamdar, J.).

13

AIR 1956 Bom 74 (DB). In this case the defendant undertook to sell certain shares of the plaintiff for him at a specified price within a specified period and if he failed to do so,



purchase these shares from the plaintiff at the specified price. The defendant failed to fulfil

his obligations.

14 Similar to spot delivery contracts. A ready delivery contract was defined as a contract for

the purchase or sale of securities for performance of which no time is specified and which is

to be performed immediately or within reasonable time.

15 Gill & Co., Summons for Judgment No. 511 of 1997 in Summary Suit No. 4556 of 1996

dated 6-4-1999. In this case, the order granted unconditional leave to defend to the

defendants. The reasons were separately recorded in an oral judgment and hence not

available.

16 It is interesting to note the observation of Archana Rajaram and Amrita Singh in their

article, “Options, puts and the law”, <http://www.livemint.com>, 10-2-2009 — “The Court

appears to have reached such a conclusion solely by relying on a summons for judgment

passed in 1997, which, in turn, had relied on a ruling passed by the Supreme Court. However,

the suit filed in connection with the summons for judgment was dismissed in 2005 andconsequently, had no bearing.

17 (1992) 1 SCC 160 (two-Judge Bench).

18 Para 6.

19 (2006) 131 Comp Cas 42 (Del) (A.K. Sikri, J.). SLP dismissed by the Supreme Court on 7-

4-2006.

20 V.B. Rangaraj v. V.B. Gopalakrishnan, (1992) 1 SCC 160.

21 Paras 8 and 9.

22 (2004) 9 SCC 204 (two-Judge Bench).

23 Pushpa Katoch v. Manu Maharani Hotels Ltd., (2006) 131 Comp Cas 42 (Del).

24 Jethalal C. Thakkar v. R.N. Kapur , AIR 1956 Bom 74 (DB).

25 Paras 3, 4 and 5.

26 Economic Times, 2-2-2002.

27 Niskalp Investments and Trading Co. Ltd. v. Hinduja TMT Ltd., (2008) 143 Comp Cas 204

(Bom).

28 Jethalal C. Thakkar v. R.N. Kapur , AIR 1956 Bom 74 (DB).

29 Pushpa Katoch v. Manu Maharani Hotels Ltd., (2006) 131 Comp Cas 42 (Del).

30 Please see, M.C. Sarkar, Specific Relief Act , 15th Edn., (Wadhwa and Company: Delhi,

2005), p. 91.



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Are Option an Option