Indian Regulators Recognise Optionality Clauses in Investment Transactions: A Less Uncertain Path to M&A in India

With the slowing down of the Indian economy, the Indian Government has been accused of “policy paralysis” by business, media and its political opponents.  To signal its intent to continue with policy reforms, certain sectors such as multi-brand retail trade, telecommunications and credit information were further liberalised for foreign direct investment, in the recent past. 
 
The government also has been micro managing through certain regulatory processes to bring a sense of greater certainty in the investment transaction environment in India.  This article analyses the regulatory shifts related to “optionality clauses” that are commonplace in Indian investment transactions and its probable impact on investment transactions.
 
Optionality clauses deal with the option to sell and/or purchase the underlying securities related to investment transactions.  Investors investing in equity or hybrid securities like compulsory and mandatory preference shares (CCPS) /debentures (CCD), through the optionality clause, have the ability to contractually secure their exits.  India’s security regulator the Securities & Exchange Board of India (SEBI), did not earlier permit the enforcement of optionality clauses(1).
 
The Reserve Bank of India (‘RBI’), India’s federal bank, was also not in favour of the use of ‘put and call’ options in investment transactions under the Foreign Direct Investment (FDI) scheme. 
 
Even under the erstwhile Companies Act 1956, the optionality clauses related to public company transactions were considered (by certain judicial decisions) as fundamentally opposed to unrestricted transfer of shares though there have been judicial precedents that have upheld that optionality clauses, per se, are enforceable. 
 
However, there has been a significant shift in the substantive law and the regulations which now seem to make enforceable such optionality clauses.  In a brief overview, the shift in the regulatory positions is explored in the ensuing paragraphs. 
 
Section 58 (2) of the Companies Act 2013
 
In the context of the restriction on transfer of securities of public companies, the newly enacted Companies Act 2013, under its Section 58(2), has now expressly provided to enforce contractual arrangements in respect of transfer of securities.  This means that restrictive transfer conditions such as optionality clauses are now statutorily enforceable.  This can be regarded as the much needed certainty in the substantive law, to remove the earlier ambiguity surrounding restrictions on transferability of securities of a public company. 
 
SEBI Notification
 
SEBI by way of a notification dated 3 October 2013 (‘SEBI Notification’), has now validated contracts for purchase or sale of securities pursuant to exercise of an option.  The Notification, however, has also stated that the underlying securities related to “optionality clauses” are subject to certain conditions such as (i) the title and ownership of the underlying securities is held continuously by the selling party to such contract for a minimum period of one year from the date of entering into the contract; (ii) the price or consideration payable for the sale or purchase of the underlying securities pursuant to exercise of any option contained therein, is in compliance with all the laws for the time being in force as applicable (meaning that the pricing guidelines prescribed by the exchange control law is to be adhered); and (iii) the contract is settled by way of actual delivery of the underlying securities.
 
It is to be noted though that the SEBI Notification applies prospectively and therefore it does not validate contracts entered into prior to the date of the SEBI Notification.
 
RBI’s Circular 86
 
The RBI, vide Circular No. 86 dated 9 January 2014, now enables optionality clauses attached to equity shares, CCPS and CCDs to be issued to foreign investors under the FDI Scheme.  The optionality clauses shall further be subject to the following conditions:
 
(i) a minimum lock-in period of one year or such period as mentioned under FDI Regulations (whichever is higher), starting from the date of allotment of such shares or debentures;
 
(ii) after the lock-in period, the foreign investor exercising the option can exit at a price which shall not be less than the market price at recognised stock exchanges for listed companies; and not less than the ROE (return on equity) as per the latest audited balance sheet for unlisted company;
 
(iii) In case of CCDs and CCPS, the price may be worked out at the time of exit as per any internationally accepted pricing methodology duly certified by a Chartered Accountant or a SEBI registered Merchant Banker.
 
It is to be noted that optionality clauses should not guarantee a foreign investor an assured exit price at the time of entering into investment transactions.
 
Pricing Guidelines for Exit
 
With the regulatory shift in positions on exits, the key outstanding issue could be the pricing guidelines formulated by the RBI in the context of exits of foreign investments.  There now appears to be two exit valuation mechanism; one with respect to securities with optionality clauses and others without. 
 
The pricing guidelines related to securities of listed companies with optionality clause would be in accordance with the market price at the time of exit prevalent at the recognised stock exchanges.  It would be pertinent to mention that methodology of arriving at the market price has not been prescribed unlike transaction agreements without optionality clause (for which exit price is benchmarked in terms of the SEBI prescribed guidelines on preferential allotment of shares).  For, unlisted securities with optionality clause, the pricing guidelines is based on the return on equity (RoE) as per latest audited balance sheet whereas, unlisted securities without optionality shall be priced using discounted cash flow (DCF) method. 
 
Also, the RBI has made it clear that all existing foreign investment contracts that promised exit options with assured returns to foreign investors need to be reworked to qualify as FDI compliant. 
 
Conclusion
 
The foreign investment regulatory landscape has now featured optionality clauses to bring in the much needed clarity for investment transactions.  Given so, it now needs to be seen whether the new regulatory prescriptions on pricing guidelines will bring out any further teething problems for investment transactions in India.

Debanjan is a Partner in the Corporate & Commercial practice of Fox Mandal. He specializes in cross-border M&A. Anjali Haridas is an Associate in the Corporate & Commercial practice of Fox Mandal.
 
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