Share purchase agreements (SPA) outline the terms and conditions of buying or selling the company’s securities on the stock exchange. This agreement is of quite a lot of importance and is the key to preserving the clarity between buyers and sellers, as it provides vital details, such as shareholder rights, responsibilities, etc. In the absence of this agreement, it would be difficult to safeguard the interests of all parties involved.
An ‘Option Clause’ in a contract defines the rights and obligations of the investors. It allows them to ‘call’ or ‘put’ the equity they hold on to the table and compel the founder/promoters of the company to buy it at the agreed upon price.
Put Option Clauses
In October 2013, the Securities and Exchange Board of India (SEBI) released a notification that revoked the ‘SEBI 2000 Notification’. It also brought ‘option contracts’ under the ambit of permissible contracts, which falls under the Securities and Contract Regulation Act (SCRA).
As per SEBI’s 2013 Notification, option contracts related to buying/selling securities could be added to shareholder contracts and in the company’s articles of association if:
- The amount payable for the sale/purchase of underlying securities complies with all the applicable laws that are effective at the time.
- The seller has held the title and ownership of the underlying securities continuously for at least a period of one month from the date they signed the contract.
- The contract shall be deemed settled after the delivery of underlying securities. In addition, such agreements must adhere to the terms listed under the Foreign Exchange and Management Act, 1999 (FEMA).
As per the explanation of SEBI’s 2013 Notification, Section 18A of the SCRA, read with Section 23(1)(d) of the SCRA, shall not be applicable to contracts that involve an option clause. In accordance with this, the definition of contracts in derivatives is entirely removed and does not anymore include ‘option clause contracts’ under it.
| Derivative Contract refers to contracts whose value is determined from the value of one or more underlying assets. |
- They are traded on some recognized stock exchange,
- They are resolved on the clearing house of the recognized stock exchange as per the laws of that stock exchange.
| Note: The SEBI 2013 Notification clarifies that it shall not have any effect on backdated contracts. This basically means that no contract that was entered into prior to the date of the notification shall be affected by this notification. |
Landmark Judgement - Edelweiss Financial Services Ltd. vs. Percept Finserve Pvt. Ltd.
The dispute between Edelweiss Financial Services and Percept Finserve led to a landmark judgement with respect to Put Option Clauses in India.
Edelweiss Financial Services entered into a share purchase agreement on 8 December 2007 for the purpose of buying 2,28,374 shares of Percept Limited, that were, at the time, held by Percept Finserve, for INR 20 crores. As per the SPA, Percept Limited and Percept Finserve had to fulfill certain conditions, which included the following:
- Restructure the Percept Group by 31 December 2007 and share the documents, as proof of completing the process, with Edelweiss,
- Not to get rid of any assets by selling to third parties, and
- Transfer the shareholding of all shareholders of all associated companies to Percept Limited.
Edelweiss raised a dispute where it stated that the SPA had been broken as one of the crucial requirements of the agreement – restructuring of the group – had not been fulfilled. As such, it claimed that they had the right to sell back the securities to Percept Finserve at a price that counted in 10% of the purchasing price as internal rate of return (IRR).
As the mandatory requirements were not fulfilled even by the increased deadline, Edelweiss implemented the Put Option Clause and sent a letter to Percept Finserve to execute Edelweiss’s Put Option clause by 12 January 2009.
After Percept Finserve failed to comply to this request and implement Edelweiss’s Put Option, the latter filed an arbitration, stating that Percept Finserve was required to repurchase the shares it sold to Edelweiss at an IRR of 10% of the purchase price in case the SPA was violated.
Arbitral Award
The sole arbitrator hearing the case deemed that Edelweiss’s Put Option clause was not valid under the Securities and Contract Regulation Act because:
- It was a forward contract, which was prohibited under Section 16 of the SCRA read with March 2000 Notification, and
- The option was related to the future purchase of shares, which are not being traded currently on a recognized stock exchange. This was forbidden under the Securities and Contract Regulation Act.
The arbitration’s result was not satisfactory for Edelweiss, which, thereafter, contested the award of the arbitration under Section 34 of the Arbitration and Conciliation Act, 1996. A single-judge bench of the Bombay High Court set aside the result of the arbitration on the grounds that:
- Edelweiss’s Put Option was not a contract relating to the sale/purchase of shares in the future.
- The contract would only come into effect if Percept Finserve failed to deliver on the requirements mentioned beforehand and if Edelweiss decided to execute the ‘Put Option clause’.
- The Put Option was Edelweiss’s right to resell the purchased shares to Percept Finserve in the event of failure on the latter’s part.
- Simply because the original seller is allowed to repurchase the securities by a specific date, the contract shall not cease to be a ‘spot delivery contract’.
Some Key Arguments of the Case
- Edelweiss pointed out that the arbitrator’s award did not comply with the judgement passed by the Bombay High Court in the case of MCX Stock Exchange Ltd. vs. SEBI, which is commonly known as the ‘MCX Decision’.
- The validity of the MCX Decision was upheld by the Bombay High Court in this case as well. It stated that the Put Option clauses in contracts entered before 2013 were not deemed as ‘forward contracts’ under the SCRA. This was because option contracts were performed on a spot delivery basis. It further added that granting some time to the shareholders to repurchase securities after executing the Put Option did not necessarily classify the contract as a ‘forward contract’.
- Edelweiss argued that the Put Option did not fall under the definition of a derivative contract under Section 18 of the SCRA. Considering it was not derived from any underlying assets or securities, Edelweiss stated that it shall not fall under the scope of a derivative.
- Furthermore, as the Put Option was a private contract between two people and was not actually traded on a recognized stock exchange, it would not be considered as a derivative contract under Section 18A of the SCRA.
Edelweiss tried to overturn the result of the arbitration by putting forward these claims and arguing that Put Option was not a ‘forward or derivative contract’ and, thus, was not unlawful.
Conclusion
Although it has been in effect for a long time, the confusion related to spot delivery contracts has yet to be clarified. However, the recent amendments to relevant provisions have brought relief to both Indian and foreign investors. Besides, with more clarity about Put Option clauses in contracts, investors are bound to feel less stressed about potential conflicts between them and the entity they are investing in.
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