Distinguishing between Options and Forwards

By Falak Dutta (rajeev@vinodkothari.com)

Ruling of Bombay High Court

The Bombay High Court on March 27, 2019, in the case of Edelweiss Financial Services v. Percept Finserve Pvt. Ltd.[1], ruled out an award passed by a sole arbitrator with respect to a share purchase agreement (SPA). The High Court allowed enforcing of a put option clause to be exercised by Edelweiss, the appellant, to sell back the shares it had acquired from Percept Group, the respondent.

Before delving into the proceedings of the aforesaid case, it is important to understand certain basic concepts, to appreciate the ‘option clause’ in the case. An option is a derivative contract which gives the holder the right but not the obligation to buy (call) or sell (put) the underlying within a stipulated time in exchange for a premium. Options are not just traded on exchanges but are also used in debt instruments (eg. callable and puttable bonds), private equity and venture capital investment covenants. Even insurance is a type of option contract where the insured pays monthly premium in exchange of a monetary claim upon the future occurrence of a contingent event (accident, disease, damage to property etc.).

 

Facts of the case

Edelweiss Financial Services Pvt. Ltd. entered into a share purchase agreement (SPA) dated 8, December, 2007 with the Percept Group where it invested in the shares of Percept Group subject to a condition that the latter shall restructure itself as agreed between the parties followed by an IPO. Under the terms of the SPA, the appellant (Edelweiss) purchased 228,374 shares for a consideration of Rs. 20 crores. One of the conditions in the agreement, required Percept to entirely restructure by 31st December, 2007 and to provide proof of such restructuring. Upon failure of compliance by the respondent, the date was further extended to 30 June, 2008 with obligation to provide documentary evidence of completion by 15th, July 2008. Upon non-fulfillment within the extended date, Edelweiss had the option to re-sell the shares to Percept, where Percept was obligated to purchase the shares at a price which gave the appellant an internal rate of return of 10% on the original purchase price.

As was the case, Percept failed to restructure itself within the stipulated time. Subsequently in view of this breach Edelweiss exercised the put option and Percept was required to buy back the shares for a total consideration of Rs. 22 crores. Since the respondent refused to comply the appellant invoked the arbitration clause in the SPA and a sole arbitrator was appointed to adjudicate the dispute. The arbitrator submitted that despite Percept being in breach of the conditions in the SPA, the petitioner’s claim to exercise the put option was illegal and unenforceable, being in conflict with the Securities Contracts regulation Act (SCRA), 1956. The unenforceability was proposed on two grounds. First, for the clause being a forward contract prohibited under Section 16 of SCRA read with SEBI March 2000 notification, which recognizes only spot delivery transactions to be valid. Secondly these clauses were illegal because they contained an option concerning a future purchase of shares and were thus a derivatives contract not traded on a recognized stock exchange and thus were illegal under Section 18 of SCRA, which deals with derivative trading.

Aggrieved by the arbitrator’s order, Edelweiss challenged it before the Bombay High Court under section 34 of the Arbitration & Conciliation Act, 1996.

 

The Judgement

The Bombay High Court observed the reasoning of the order by the arbitrator and the contentions made by Percept. The said order confirmed the breach caused by Percept, but found the particular clauses of put option in the SPA to be illegal under two grounds as mentioned earlier. The Court divided the judgement along the sections involved.

The first of the arbitrator’s conclusion was found untenable when referred to the judgement in the case of MCX Stock Exchange Ltd. vs. SEBI [2]which deals with such a purchase option as in the present case. The Court observed that the put option clause contained in the SPA cannot be a derivatives contract prohibited by SCRA, because there was no present obligation at all and the obligation arose by reason of a contingency occurring in the future. The contract only came into being upon the following two conditions being met: (i) failure of the condition attributable to Percept (ii) exercise of the option by Edelweiss upon such failure. Whereas a forward contract is an unconditional obligation, the option in the SPA only comes into being when the aforesaid conditions are met. Thus, the arbitrator’s claim of the clause being a forward contract disregards the law stated by the Court in MCX Stock (supra).

Subsequently, respondent (Percept Group) challenged the relevance of the MCX Stock case to the present one. In the MCX Stock Exchange case, upon the exercise of the option the contract would be fulfilled by means of a spot delivery, that is, by immediate settlement. Whereas Edelweiss’s letter by which it exercised the put option required the shares to be re-purchased with immediate effect or before 12 Jan, 2009. This deferral of repurchase upon exercise of the option was not part of the MCX Stock Exchange case’s option clause and hence is not comparable to the present case.

This too was disregarded by the Court on the ground:

“It is submitted that in as much as this exercise of options demands repurchase on or before a future date, it is not a contract excepted by the circular of the SEBI dated 1 March, 2000.

Just because the original vendor of securities is given an option to complete repurchase of securities by a particular date it cannot be said that the contract for repurchase is on any basis other than spot delivery.

There is nothing to suggest that there is any time lag between payment of price and delivery of shares.”

Now, this brings us to the second leg of the arbitrator’s award regarding the illegality and unenforceability of the SPA option on account of breach of Section 18A of SCRA, which deals in derivative trading. The following is an excerpt from Section 18A:

Contracts in derivative. — Notwithstanding anything contained in any other law for the time being in force, contracts in derivative shall be legal and valid if such contracts are—

(a)Traded on a recognized stock exchange;

(b) Settled on the clearing house of the recognized stock exchange. In accordance with the rules and bye-laws of such stock exchange.

The respondent appeals that as the put option was not of a recognized stock exchange, it stands unenforceable and illegal. In response, the court submitted that the contract does contain a put option in securities which the holder may or may not exercise. But the real question is whether such option or its exercise is illegal? The presence of the option does not make it bad or impermissible.

“What the law prohibits is not entering into a call or put option per se; what it prohibits is trading or dealing in such option treating it as a security. Only when it is traded or dealt with, it attracts the embargo of law as a derivative, that is to say, a security derived from an underlying debt or equity instrument.”

There was further cross objections filed by the respondent but it was ruled out under Section 34 of the Arbitration & Conciliation Act, which deals with the application for setting aside arbitral award. Since the provisions of Civil Procedure Code, 1908 are not applicable to the proceedings under Section 34 and the section itself does not make any provision for filing of cross objections, the appeal was ruled out.

Conclusion

This Bombay High Court ruling in favor of Edelweiss provides an important distinction of options, from forward contracts. It highlighted that although both options and forwards are commonly categorized as derivatives, they share an important difference. On one hand, a forward contract contains a contractual obligation to buy or sell, on the other hand, the option gives the holder the right or choice but not the obligation to do the same. Options have always been integral to finance, routinely appearing in corporate covenants and contracts. Options are widely observed in mezzanine financing, private equity, start-up and venture funding among others. Given the Court’s distinction of forwards from options in their very essence and nature, the author believes this ruling is likely to be useful and a point of reference in future derivative litigations.

 

[1]https://bombayhighcourt.nic.in/generatenewauth.php?auth=cGF0aD0uL2RhdGEvanVkZ2VtZW50cy8yMDE5LyZmbmFtZT1PU0FSQlAxNDgxMTMucGRmJnNtZmxhZz1OJnJqdWRkYXRlPSZ1cGxvYWRkdD0wMi8wNC8yMDE5JnNwYXNzcGhyYXNlPTA0MDYxOTEwMDAyOQ==

[2] https://indiankanoon.org/doc/101113552/

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