Enforcement of Put and Call Options – Challenges in Manoeuvring the Exit
Image credit: SEBI Bhavan, Head Office of Securities and Exchange Board of India in Mumbai by Jimmy Vikas. [CC BY-SA 3.0] via Wikimedia Commons.
Authors: Raj R. Panchmatia (Partner), Peshwan Jehangir (Associate Partner), and Parth Gokhale (Associate), Khaitan & Co, Mumbai
12th September 2017
An option contract is fundamentally an arrangement wherein a party to a contract is granted a right to exercise its option to either (a) "call" upon the other party to buy certain of its securities or assets (i.e. a call option); or (b) "put" its securities or assets and require the other party to purchase the same (i.e. a put option); typically, the right to exercise is triggered upon the occurrence or non-occurrence of certain specified events in the future. An option may be exercised at a pre-determined price or at a price determined on the basis of a prescribed formula.
Internationally, it is common to have put and call options to provide an equity investor an exit from a company. However, the enforceability of option contracts in India has for long been a grey area under Indian securities and foreign exchange control laws.
The Securities and Exchange Board of India (SEBI) has viewed such options to be in the nature of "forward contracts" or derivatives under the provisions of the Securities Contracts (Regulation) Act, 1956 (SCRA). The Reserve Bank of India (RBI) has for long harboured a view that options permitting companies to avail of funding from foreign parties at fixed returns or with downside protection, are more in the nature of a low risk debt investment (qualifying as "external commercial borrowings") rather than being higher risk equity investments. These issues have previously led to several legal impediments in enforcement of such options. The situation is however changing.
Moves towards liberalisation
The SEBI had previously held such option contracts to be invalid under the terms of the SCRA in view of the same qualifying neither as "spot delivery contracts" nor as legal and valid derivative contracts. In essence, since the right to exercise an option was to be determined on the basis of a future event, SEBI felt options were speculative in nature. The first step towards liberalising the regime governing put and call options was undertaken by way of a SEBI notification dated 3 October 2013,1 which, inter alia, permitted option contracts in shareholders’ agreements and articles of association of companies, subject to the conditions specified therein.
The SEBI further clarified, inter alia, that the said option contracts would (i) have to comply with the Foreign Exchange Management Act, 1999 (FEMA) and the regulations framed thereunder by the RBI; and (ii) the said notification would not affect or validate any contracts entered into prior to the date of the notification.
It is, however, unclear as to why SEBI did not bring about some clarity as to existing agreements and, as such, impliedly suggested that such options were previously unenforceable. Unfortunately, it will be some time now before various legacy documents and exits under older agreements are tested and/or concluded and/or eased out of the legal system.
The RBI too moved towards easing the exchange control regime governing options by way of its circulars dated 9 January 20142 and 15 July 2014,3 by way of which options attached to equity shares and compulsorily and mandatorily convertible preference shares/debentures issued to non-residents by unlisted companies were permitted subject to, inter alia, there being no guarantee of an assured return or exit price at the time of undertaking the investment. While the above amendments brought substantial clarity to prospective investors seeking to enter into an option contracts, the enforceability of numerous pre-existing option contracts remained in question.
These issues of enforcement assume greater complexity while dealing with a foreign investor in an Indian company. Several shareholders’ agreements incorporating such clauses are governed by foreign law, or contain arbitration clauses, where the arbitration is to be seated outside India. Under the laws of most foreign jurisdictions, these options are valid and easily enforceable. This has led to a spate of awards being passed in international commercial arbitrations either upholding the enforceability of such options or awarding damages to the party exercising the same. Indian parties often use the above SEBI regulations and RBI restrictions as defences in such arbitrations, and challenge the enforcement of any award on the ground that the award is contrary to the public policy of India.
Navigating the path to enforceability – Pro-enforcement approach of the Indian courts?
A series of recent judgements emanating from the Indian courts appear to be indicative of an increasingly pro-enforcement approach.
Shakti Nath & Ors. v. Alpha Tiger Cyprus Investments No. 3 Ltd. & Ors4
Certain investor entities were granted a put option under a shareholders’ agreement, exercisable in the event the conditions subsequent were not fulfilled by the "Long Stop Date". The exit price was fixed at the amount invested plus a post-tax IRR of 19% on the invested amount.
The arbitral tribunal found in favour of the investors, examining their claim as one for damages, and did not, per se, delve into the specific performance of the put obligation. The petitioners herein preferred an appeal under Section 34 of the (Indian) Arbitration and Conciliation Act, 1996 (Arbitration Act) before the Delhi High Court challenging the arbitral award on, inter alia, the following grounds:
(a) That the arbitral award was an attempt on the part of the respondent investors to enforce a put option; and
(b) That the arbitral tribunal had failed to appreciate the impact of the pricing guidelines prescribed under the RBI circular dated 15 July 2014;
The High Court dismissed the challenge raised by the petitioners and observed that the respondents had not chosen to enforce the put option but had instead claimed damages for breach of contract. The petitioners were therefore held to be bound by the terms of the contract entered into by them and the arbitral award was upheld.
While the said decision in Shakti Nath did not per se comment upon the enforceability of put option contracts, in a significant development, the court proceeded to uphold the granting of reliefs seen as incidental to the failure of the petitioners in honouring their purchase obligation. The decision of the single judge has been upheld by a two-judge bench of the High Court5 and the matter is currently pending appeal before the Supreme Court of India.6
Cruz City 1 Mauritius Holdings v. Unitech Limited7
Cruz City, a Mauritian entity obtained an award against Unitech, an Indian entity and its wholly owned subsidiary, Burley Holdings Limited. Cruz City had entered into a "Keepwell Agreement" with Unitech and Burley, which, in turn, was in confirmation for a put option extended to Cruz City by Burley and Arsanovia (a related entity of Unitech) under a separate shareholders’ agreement. Cruz City’s investment was in the form of equity shares held in Kerrush, a Mauritius incorporated entity. The said shareholders’ agreement entitled Cruz City to call upon Burley and Arsanovia to purchase Cruz City’s shareholding in Kerrush at a post-tax IRR of 15% on the invested amount, in the event that the construction of a real estate project was delayed beyond a specified period.
Upon the put obligation under the shareholders’ agreement not being honoured, Cruz City initiated arbitral proceedings against Unitech and Burley under the Keepwell Agreement. The Keepwell Agreement provided for arbitration under the rules of the London Court of International Arbitration, seated in the United Kingdom. The proceedings culminated with an award being passed, requiring Unitech and Burley to pay an amount of USD 298,382,949.34 as the purchase price, against delivery of Cruz City’s equity shares in Kerrush. Cruz City ultimately sought enforcement of the said award before the Delhi High Court against Unitech under Sections 47 and 49 of the Arbitration Act.
The respondents argued that the enforcement of the award would be contrary to the "public policy of India" as it contravened the provisions of the FEMA, and that any award which was contrary to any Indian statute would be unenforceable.
The High Court, however, dismissed the above arguments and observed as follows:
(a) While Unitech was bound to pay the purchase price to Cruz City for breach under the Keepwell Agreement, there was no stipulation that the shares had to be delivered only to Unitech.
(b) The contravention of a provision of Indian law is insufficient to invoke the defence of "public policy" to stall the enforcement of a foreign award.
(c) There had been a paradigm shift in the country’s exchange control policy between the previously existing Foreign Exchange Regulation Act, 1974 and FEMA and that the regulatory approach had now shifted from prohibiting foreign exchange transactions towards a more permissible environment.
(d) The said put option could be exercised only within a specified timeframe and was contingent upon the non-occurrence of a specified event, and hence was not an open ended assured exit option.
The court further came down heavily on what it saw as an attempt by an Indian party to renege upon its contractual obligations, regardless of having provided unambiguous representations in the investment documentation. The court described the conduct of Unitech as being ‘plainly dishonest’ and noted that permitting Unitech to resist enforcement on such grounds would be manifestly unjust in nature.
NTT Docomo Inc. v. Tata Sons Limited8
In this more recent ruling, the Delhi High Court examined the locus standi of the RBI to object to the enforcement of an award delivered in an arbitration between two private parties. Tata Sons and Docomo had entered into a shareholders’ agreement in 2009 by way of which Docomo acquired a shareholding of 26% in TTSL, a joint venture between Tata Sons and Docomo. In terms of the shareholders’ agreement, in the event TTSL failed to satisfy certain prescribed performance indicators, Tata Sons would be obligated to find a buyer for or acquire Docomo’s shares in TTSL at the higher of (a) fair value of the shares; or (b) 50% of the original investment amount.
Upon a failure on the part of Tata Sons to abide by the put obligation, Docomo invoked arbitration proceedings seated in London, and raised a claim for damages on account of breach of the representations made by Tata Sons under the shareholders’ agreement. The arbitral tribunal found in favour of Docomo and ordered Tata Sons to pay Docomo an amount of USD 1,172,137,717. Docomo subsequently sought enforcement of the award before the Delhi High Court. While the enforcement was initially resisted by Tata Sons, the parties subsequently reached a settlement under which Tata Sons agreed to withdraw its objections to the enforcement.
At this stage, the RBI filed an intervention plea before the High Court, and argued that regardless of the settlement arrived at between the parties, the impugned award was unenforceable by virtue of being illegal and contrary to the public policy of India on the basis of non-compliance with FEMA regulations. It was argued that the put option clause in the shareholders’ agreement was in violation of the RBI mandated pricing norms for option contracts.
Notwithstanding the above, the High Court held that the RBI had no locus standi to intervene in the proceedings as no provision in the Arbitration Act permitted an entity not a party to the award to intervene in enforcement proceedings. It further dismissed the argument that hearing the RBI was imperative simply because the award discussed the provisions of FEMA and the regulations framed thereunder. The High Court further clarified that what was awarded to Docomo were damages for breach of the shareholders’ agreement and not the purchase price of the shares. The plea intervention by the RBI was accordingly rejected.
On the enforceability of the provisions of the shareholders’ agreement under the terms of FEMA, the High Court held the same to be in the nature of a "downside protection" and not an "assured return" on Docomo’s investment. As the same was a mere contractual promise, it was held to be permissible under the general permissions of the RBI as prescribed under FEMA.
Although several investment agreements contain such options, a party may not be able to successfully exercise its right under these contracts. The question to be asked is whether these options really serve as a feasible exit mechanism for an investor or would such an investor in any event have to go through a long-drawn arbitration followed by enforcement proceedings before seeing the colour of money. The multiplicity of regulators has added to the already existing confusion and unless all the creases relating to enforceability of options are ironed out, these options may not be able to serve as the “exit options” that parties intend them to be. While the recent trends emanating from the courts are encouraging and are indicative of a pro-enforcement approach, it is still some time before the law relating to enforcement of exit options attains clarity.
 The Stockholm Chamber of Commerce’s latest set of rules, which also came into force on 1 January 2017, include an appendix with limited modifications of its standard rules for investor-state disputes. The Shenzhen Court of International Arbitration’s latest set of rules, which came into force on 1 December 2016, allow the SCIA to administer investor-state arbitration rules under the UNCITRAL Rules.
 RBI/2013-2014/436 A.P. (DIR Series) Circular No. 86 dated 9th January 2013
 RBI/2014-15/129 A.P. (DIR Series) Circular No. 4 dated 15th July 2014
 Judgement dated 9 February 2017 in OMP (COMM) 154/2016
 Judgement dated 8 May 2017 in FAO (OS) (COMM) 53/2017
 SLP (C) No. 0022038 of 2017
 Judgment dated 11 April 2017 in EX.P.132/2014, EA(OS) Nos.316/2015, 1058/2015, 151/2016 and 670/2016
 Judgement dated 28 April 2017 in O.M.P. (EFA)(COMM.) No. 7/2016 and IA Nos. 14897/2016 and 2585/2017
About the author
Raj Panchmatia is a Partner in the Dispute Resolution Practice group at Khaitan and Co in Mumbai. He has advised clients on a wide variety of claims under Indian Arbitration Laws, SIAC, LCIA, ICC, UNCITRAL and HKIAC.