The importance of options In the last two decades, India has recorded impressive economic growth buoyed by strong

corporate performance. To sustain such growth it is important for companies to have sufficient 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 on investment. To meet these requirements such investment normally has an exit mechanism built into the investment documentation. The most common exit mechanism is achievement of an IPO within a certain period followed by an option to divest if the IPO is not done. This option 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 international know-how. In joint venture relationships, there is often an option with one of the partners to buy 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 option? A good starting point is to describe an option. An option gives the option-holder the right to either buy a specified number of shares of, or sell a specified number of shares to, the option provider at a specified price on the occurrence of an event. If the option-holder has the 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 buy or sell shares on the occurrence of an event. The contract therefore is in force when executed but becomes effective only when the event has occurred. The option provider is only bound when the option is exercised. In sum, two things must happen for the option provider to be bound (i) the event for exercise of the option must have occurred; (ii) the option must be exercised by the option-holder after (i). Similarly, the option-holder is only bound when he exercises the option. There is no obligation on the option-holder to purchase shares until such exercise. Why is an option contract considered unenforceable? For a public company: i an option contract, it is argued, is not a spot delivery contract and hence violates the requirements 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 public company, whether listed or not, and not to a private company. The genesis of these arguments 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 securities 3. Securities include inter alia shares, scrips, stocks, bonds, debentures, debenture stock or 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 in securities5. A spot delivery contract provides for (i) actual delivery of securities and payment of 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 Central Government may declare by notification that no person in the notified area shall enter into specified contracts for sale or purchase of security except with the permission of the Central Government. In June 1969, the Central Government issued a Notification7 (the 1969 Notification) under Section 16 of SCRA, which applied to the whole of India, prohibiting all contracts 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 and the 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 issued Notifications 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 the commencement 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 and commerce or economic development, specify any class of contracts to which SCRA does not apply by notification in the Official Gazette. In June 19619 the Central Government specified contracts for pre-emption or similar rights contained in the promotion or collaboration agreements or in the articles of association of limited companies as contracts to 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 basket of rights as contracts for pre-emption in collaboration agreements, since Section 20 of SCRA was still in force at the time of the 1961 Notification, it may be more appropriate to conclude that option contracts were excluded. In addition to the above provisions, it is important to note that based on the use of the phrase other marketable securities of a like nature in the definition of securities, SCRA has been held to apply only to public companies, whether listed or not, and not private companies. In this regard, marketable has been interpreted to mean capable of being listed. 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 capable of being listed. Hence, SCRA only applies to securities of a public company10. The argument against option contracts in relation to shares of a public company is simple. Such contracts provide for the purchase or sale of securities, in future, at a specified price. Since the actual delivery of securities and payment of price do not take place on the date 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 the Notifications issued on 1-3-2000. If such consent is not obtained, the parties to the option contract would violate the provisions of SCRA and be liable to fine of up to Rs 25 crores and/or imprisonment of up to 10 years11. This argument finds support in the judgment of the Bombay 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 plaintiffs had 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 option was exercised by the plaintiffs but not honoured by the defendants. The plaintiffs filed a summary suit for recovery of money from the defendants under the put option. The plaintiffs argued for the validity of the put option contract relying on the Division Bench judgment of the Bombay High Court in Jethalal C. Thakkar v. R.N. Kapur13 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 delivery contracts14. 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 it violated SCRA and could not be enforced16. On this ground, the Court granted the defendants unconditional leave to defend while transferring the suit to the list of commercial causes. 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 that restrictions on transfer of shares not contained in the articles of association of a company would not bind the company or the shareholders. Although this case involved shares of a private company, the reasoning of the Court has been applied to all companies. The Court relied on Section 82 of the Act which provides that shares are movable property transferable in the manner provided by the articles of a company and other provisions of the Act, to observe, 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 the shareholders. The vendee of the shares cannot be denied the registration of the shares purchased 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 agreement had been entered into by the appellant and the respondents which gave each party a preemptive right to purchase shares of the other parties in a public company. This pre-emptive right 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 the Company Law Board which ruled in favour of the respondents, the Delhi High Court held: ( i) relying on Rangaraj20, 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 the articles of the company; (iii) even if the pre-emptive right was included in the articles it would be 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 the Supreme Court decision in M.S. Madhusoodhanan v. Kerala Kaumudi (P) Ltd.22, where it was held that an agreement to transfer shares not contained in the articles of a private company 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 those shares 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, 1872 makes 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 call option 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 extent possible, 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 option contracts has been deleted. Further, the 1961 Notification shows intent to uphold rights in collaboration agreements in the interests of trade, commerce and economic development. The 1961 Notification followed by the repeal of Section 20 shows legislative intent that option contracts should be valid. Further, is an option contract a contract relating to the sale or purchase of securities? I submit 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 on the occurrence of a contingency, which could be the lapse of time or the occurrence or nonoccurrence of an event within a specified period. Further, the option must be exercised before the option provider is bound. Consequently, until the occurrence of the contingency and 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 a floating charge which floats over an asset pool of a company until the occurrence of an event which 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 the option contract is nothing more than a commitment and should not fall foul of the spot delivery requirements under the SCRA. In support of my argument, I would like to quote Chief Justice Chagla's observations in Jethalal C. Thakkar case24 : It is clear on a plain reading of this contract that no obligation attached with regard to the purchase of these shares on the part of the defendant until the contingency contemplated occurred after the lapse of 12 months. A clear distinction must be borne in mind between a case where there is a present obligation under a contract and the performance is postponed to a later date, and in a case where there is no present obligation at 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 date when the contract was entered into there was no present obligation with regard to the purchase or sale of shares. It was definitely not a case where a present obligation having been created the parties agreed to postpone performance. The parties intended and made their intention clear by the language of the contract itself that there was no obligation upon the 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 was no 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 The Future of Options26, 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 completed contract (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 grant thereof. 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 on the 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 any court or regulatory authority in this behalf. The authors go on to state: This seems to be a classic case of an age-old legislation (such as the SCRA) being implemented in the present era, without any alterations being made to cater 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 one reconcile the fact that while derivatives (such as options) can now be legally traded on the stock exchange, the legal regime does not seem to permit the creation of such options themselves 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 requisite modifications are made to the legal regulations, such that genuine commercial transactions which 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 by the committee appointed by SEBI under the chairmanship of Justice Dhanuka which recommended 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 this order was in a summons for judgment where the Court's sole purpose is to determine whether 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 and technical distinctions between SCRA and the Bombay Securities Contract Control Act to override the sound reasoning of the Division Bench judgment in Jethalal C. Thakkar28 further diminishes the value of this order. In sum, based on the legislative intent of repealing Section 20, SCRA and the contingent nature of option contracts, I believe that option contracts do not 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 the option 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 the call option is exercised? Practically, this may be the case but, unless the contract specifically restricts transferability, there is no legal bar to transfer. Therefore, absent specific restrictions in the contract, it is possible for an option provider to deal in his shares until the call option is exercised, provided he is in a position to sell the number of shares constituting the call option 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 a restriction on transfer of shares, it may fall foul of Section 111-A of the Act read with Section 9 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 option provider 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 position to argue for specific performance. Under Section 10 of the Specific Relief Act, 1963 a contract 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 an unlisted 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 are of an unlisted public company, the option-holder may be in a position to specifically enforce the contract. For a listed public company, damages would be the only remedy30. Hence, an option-holder appears adequately protected if a call option is interpreted as not imposing a fetter on transfer of shares. Conclusion To conclude: i Options are vital to commercial arrangements between investors/shareholders/joint venture partners. Courts should facilitate such arrangements to encourage economic growth. ii Options do not lead to undesirable speculation in securities. This is clear from the deletion 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 exercised after 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 solely those 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. Section 2(a) of SCRA. Section 2(h) of SCRA. Section 2(d) of SCRA. Section 2(i) of SCRA. No. S.O. 2561 dated 27-6-1969. No. S.O. 184(E) and No. S.O. 185(E). 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. (2008) 143 Comp Cas 204 (Bom) (S.U. Kamdar, J.).

12

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 and consequently, had no bearing.
17

(1992) 1 SCC 160 (two-Judge Bench). Para 6.

18

19

(2006) 131 Comp Cas 42 (Del) (A.K. Sikri, J.). SLP dismissed by the Supreme Court on 74-2006.
20

V.B. Rangaraj v. V.B. Gopalakrishnan, (1992) 1 SCC 160. Paras 8 and 9. (2004) 9 SCC 204 (two-Judge Bench). Pushpa Katoch v. Manu Maharani Hotels Ltd., (2006) 131 Comp Cas 42 (Del). Jethalal C. Thakkar v. R.N. Kapur, AIR 1956 Bom 74 (DB). Paras 3, 4 and 5. Economic Times, 2-2-2002.

21

22

23

24

25

26

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

29

30

Please see, M.C. Sarkar, Specific Relief Act, 15th Edn., (Wadhwa and Company: Delhi, 2005), p. 91.