Article

EXIT OPTIONS IN EQUITY INVESTMENTS IN

INDIA: RECENT ISSUES ON LEGALITY

-Soma Bagaria
[email protected]

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This write up is intended to initiate academic debate on a pertinent question. It is not intended to be a
professional advice and should not be relied upon for real life facts.

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It is common for an investor to secure its exit rights before making an investment.
Typically, the exit mechanisms include an initial public offer (IPO), buy back of shares
by the investee company and a put option and a call option or tag along / drag along
rights. However, the foreign investments have taken a hit with the ongoing debate on the
issue of enforceability of options with no clarity on the same provided by the Indian
regulatory authorities. This article seeks to analyse the issue of whether options, as an
exit mechanism for private equity investors is enforceable under the Indian laws.
1.

BACKGROUND

1.1

Meaning of put and call options

An option is a right or entitlement, but not an obligation, of a person to buy or
sell, as the case may be, an underlying asset in future at a predetermined price.
Such asset for our discussion purposes is shares.
A put option is the right of a shareholder of a company to sell those shares to
another existing shareholder at a specified price at the time such holder wishes to
exit its investments in the investee company. Such other shareholder shall have an
obligation to purchase those shares at the said predetermined price.
A call option grants a shareholder of a company the right to acquire shares in the
company from another existing shareholder at a predetermined price. Such other
shareholder shall have an obligation to sell the shares to the shareholder
exercising his call option. To put it simply, call option is converse of a put option.

1.2

Use of call option and put option as exit mechanism for private equity
investors
The exit provisions in a contract hold importance particularly in cases of foreign
investment where the foreign investor seeks to ensure his exit rights vis--vis the
investee company and other shareholders of the investee company. The investors
primarily rely on the investee company floating their shares in an IPO, i.e. listing
of shares, which provides liquidity and ample exit opportunities to the exiting
shareholders. However, since listing of a company has various dimensions

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attached to it which may not make listing a feasible exit mechanism, the investors
fallback on other options for their exit.
For a foreign investor the aforesaid put option and call option hold different
significance depending upon the strategy and the kind of investment:

1.3

(a)

Call options (since provide a right to acquire more shares) are particularly
useful to strategic investors in sectors having sectoral caps. This is because
such investors take active interest in the functioning and operation of the
company and spend considerable time, effort and resources in establishing
the business of the investee company. Therefore, a call option gives them
the right to acquire further shares in the event there is relaxation in the
sectoral cap thereby enhancing the foreign shareholding limit. Typically,
such option is of significance in a joint venture or acquisition transaction
between Indian and foreign parties wherein the foreign investor is given a
right to acquire shares from the Indian shareholders in case of increase in
sectoral limit.

(b)

Put options (since they provide a right to sell their shares) are useful for
financial investors who make investments to reap benefits and earn profit
from the investment, such investors primarily being private equity and
venture capital investors. The put option may be vis--vis the investee
company or the shareholders of the investee company. Since the company
is subject to several regulatory restrictions when buying-back its own
shares, typically the put option is obtained vis--vis the shareholders of the
investee company.

The Debate
(a)

Whether options are permissible in equity instruments under the foreign

direct investments (FDI) in India.

(b)

Whether options contracts are valid and legal under the Securities
Contracts (Regulation) Act, 1956 (the SCRA).

(c)

Whether options on shares of a public company and a private company are

permissible under the Companies Act, 1956 (the Companies Act).

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2.

TREATMENT OF OPTIONS FOR FDI PURPOSES

2.1

Securities with Options Treated as Debt

Vide the FDI Policy (Circular 2 of 2011) dated September 30, 2011, which
became effective from October 1, 2011 (the FDI Circular), the Department of
Industrial Policy and Promotion from the Ministry of Commerce and Industry
inserted a new clause 3.3.2.1 which provided that:
Only equity shares, fully, compulsorily and mandatorily convertible debentures
and fully, compulsorily and mandatorily convertible preference shares, with no inbuilt options of any type, would qualify as eligible instruments for FDI. Equity
instruments issued/transferred to non-residents having in-built options or
supported by options sold by third parties would lose their equity character and
such instruments would have to comply with the extant ECB guidelines.
[emphasis supplied]
Such a provision, in our view, was brought because of concerns of the Regulators
that since options warranted safe exits, the foreign investors are not taking
genuine equity risks in Indian companies and instead seeking an exit at
guaranteed prices (which classifies such investment as debt). This raised a lot of
criticism by the investors as such a provision affected genuine commercial
transactions, where the foreign investor is provided an exit at the then prevailing
fair market value (which, of course, would abide by the pricing norms). Also, in
the sectors where external commercial borrowings (ECB) are permitted, there
was no reason as to why an investor would prefer to disguise its investment as
equity.
Accordingly, by a recent amendment in this provision was recently deleted from
the FDI Circular1, which has been welcomed by the investors and joint venture
partners and collaborators.

2.2

Status Quo maintained

See Press Release on FDI Policy (Circular 2 of 2011) dated October 31, 2011.

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While a prima facie reading of the deletion of clause 3.3.2.1 may be interpreted to
mean that options in equity instruments are now permissible. However, since it is
unclear whether the deletion sets out a new policy or merely intends to maintain a
status quo, ambiguity in the position still prevails and, thus, caution is imperative.
3.

VALIDITY OF OPTIONS UNDER SCRA

3.1

Statutory Provisions
The SCRA was enacted with a primary intention of preventing undesirable
transactions in securities. Post 1956, there has been a few amendments in the
statue with a view to identify the contracts which would result in such undesirable
transactions.

3.1.1

The Central Government has, in the interest of trade and commerce or the
economic development of the country, the power under Section 28(2) of
the SCRA to exempt a specified class of contracts from the purview of the
SCRA. In exercise of such power, the Central Government vide its
Notification No SO 1490 dated June 27, 19612, 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 shall not apply. No specific mention was made
to options but a simple interpretation suggests options to be similar to
pre-emption. There was no discussion or issue regarding validity of
options under SCRA at that stage.

3.1.2

Further, the Central Government vide its Notification dated June 27, 19693
under Section 16 (which empowers the Central Government to prohibit

The relevant paragraph of the 1961 Notification is as follows:

Whereas the Central Government is satisfied that in the interests of trade and commerce or the economic
development of the country, it is necessary or expedient so to do; Now, therefore, in exercise of the powers
conferred by sub-section (2) of section 28 of the Securities Contracts (Regulation) Act, 1956 (42 of 1956),
the Central Government hereby specifies 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 the said Act shall not apply. [emphasis supplied]
3
The relevant paragraph of the 1991 Notification is as follows:
In the territory to which the Act extends, no person can except with the permission of the Central
Government enter into any contract for the sale or purchase of securities other than such spot delivery

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certain contracts in specified securities in any state or area in India) of the
SCRA prohibited all kinds of contracts except spot delivery contract4 or
contract for cash or hand delivery or special delivery in any security under
SCRA. Any other contract could only be entered into with the permission
of the Central Government. This Notification sought to restrict forward
contracts. Forward contracts are over-the-counter derivative contracts by
which one party agrees to deliver shares to another party on a
predetermined date at a predetermined price. Unlike an option contract, a
forward contract does not depend upon the exercise of an option by one of
the parties.
3.1.3

Section 205 of the SCRA, which provided that all options in securities
entered into after the commencement of SCRA or those entered before
SCRA but remained to be performed were illegal. This provision
specifically prohibited options under SCRA. However, this provision was
deleted by the Securities Laws (Amendment) Act, 1995 thereby leaving the
issue for judicial interpretation. This has been the turning point which has
triggered the debate.

3.1.4

In 2000, provision was inserted in SCRA providing that a derivative

contract shall be invalid if they are settled outside the stock exchange.

contract or contract for cash or hand delivery or special delivery in any security as is permissible under the
Act and the Rules and bye-laws and the regulations of the recognised stock exchange. [emphasis supplied]
4
Spot delivery contracts are those where the actual delivery of securities and the payment of a price occurs
either on the same day of the contract or on the following day. Therefore, any contract entered into outside
the stock exchange (such as an OTC transaction), where either the actual delivery of securities and payment
of price is deferred beyond a day of the contract would be void.
5
Section 20 of SCRA, prior to omission read as follows:
Prohibition of options in securities (1)Notwithstanding anything contained in this act or in other law for
the time being in force, all options in securities entered into after the commencement of this act shall be
illegal.
(2) Any option in securities which has been entered into before such commence and which remains to be
performed, whether wholly or in part, after such commencement shall, to this extend, become void.

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3.1.5

3.2

Further, in 2000, the 1969 Notification was rescinded. However, SEBI

vide its Notification No SO 184(E) dated 1 March 2000 issued directions
having effect similar to that of the 1969 Notification.6

Whether options are derivatives

3.2.1 Section 2(ac) of the SCRA provides an inclusive definition of the term
derivative which is stated to include:
(a)

a security derived from a debt instrument, share, loan, whether

secured or unsecured, risk instrument or contract for differences or
any other form of security;

(b)

a contract which derives its value from the prices, or index of

prices, of underlying securities.

3.2.2 In principle, the following four conditions have to be satisfied for a

contract to be called a derivative:

(a)

The value of which is derived from one or more underlying and the
value of the derivative changes in response to changes in an
underlying price or index;

(b)

Has one or more notional values;

(c)

No actual delivery shall take place; and

In exercise of the powers conferred by sub-section(1) of section 16 of the Securities Contracts

(Regulation) Act, 1956the Securities and Exchange Board of India (hereinafter referred to as the
Board) being of the opinion that it is necessary to prevent undesirable speculation in securities in the
whole of India, hereby declares that no person in the territory to which the said Act extends, shall save with
the permission of the Board, enter into any contract for sale or purchase of securities other than such spot
delivery contract or contract for cash or hand delivery or special delivery in any securities or contract in
derivatives as is permissible under the said Act or the Securities and Exchange Board of India Act, 1992
and the rules and regulations made under such Acts and the rules, bye-laws and regulations of a recognized
stock exchange [emphasis supplied]

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(d)

That requires little or no initial net investment (or significantly less

than the investment required to purchase the underlying
instrument); and

(e)

That is net-settled at a future date.

3.2.3 Analysing the above conditions, it is clear that a contract to pay a certain
amount at a later date on happening of a certain event, or a contract of sale
/ purchase at a later date at a predetermined price cannot be construed as a
derivative. We are, therefore, of the opinion that a put and call option are
not forms of derivative, and hence, it will not attract the provisions of
SCRA in relation to derivatives.
3.3

Judicial Interpretations
3.3.1

In an early decision of the Division Bench of the Bombay High Court7, a

view was taken that the test to be applied to determine validity of a
contract is:
(a)

whether it is a contract for the purchase or sale of securities and

whether it is to be performed within a specified time; or

(b)

whether no time is specified in the contract and the contract is to be

performed immediately or within a reasonable time.

The Division Bench also said that distinction must be made between a case
where:
(a)

there is a present obligation under a contract and the performance is

postponed to a later date; and

(b)
where there is no present obligation at all and the obligation arises
by reason of some condition being complied with or some
contingency occurring.

Jethalal C Thakkar v. RN Kapur , AIR 1956 Bom 74

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If the contract falls under categories (b) of the preceding paragraphs then it
is not a case where a present obligation is created and its performance is
postponed.

3.3.2

The Supreme Court in the case of BOI Finance Ltd. v. Custodian8, ruled
that in case of a ready-forward contract, a ready leg (i.e. purchase or sale
of securities at a stated price which in executed on payment of
consideration for the spot delivery of the security certificates together with
transfer forms) is valid and lawful but the forward leg (i.e. repurchase of
the same securities on the later date at a specified price to be paid) is hit by
the provisions of the SCRA and accordingly shall be ignored.

3.3.3

A view was taken by the Bombay High Court that a contingent contract is
within the scope and applicability of the SCRA.9 The question arose in the
case of Niskalp Investments and Trading Co. Ltd. v. Hinduja TMT Ltd10,
where there was a buyback agreement to repurchase the certain specified
shares if the shares were not listed on the stock exchange by a certain
agreed date. In this case, the Bombay High Court held that a contingent
contract for an arrangement of buyback of shares is hit by the provisions of
the SCRA is in invalid in law.

3.3.4

It is to be noted that the rulings of respective Courts as stated above

involved contracts for sale and purchase of securities and not options.
However, recently SEBI has in two cases involving shares of listed
companies very clearly has been of the view that put and call options are
invalid and unenforceable, and will not be given effect to by the regulator.
One of such ruling was in relation to the public takeover of Cairn India
Limited where the parties had entered into put and call options
arrangements11. SEBI took a view that put option and call option
arrangements and the right of first refusal do not conform to the
requirements of a spot delivery contract nor with that of a contract of
derivatives as provided under Section 18A of the SCRA and, therefore,

[1997] 10 SCC 488, AIR 1997 SC 1952

See supra note 8.
10
[2008] 143 Comp. Cas. 204 (Bom). In this case the BOI Finance case was relied upon.
11
See Letter of Offer to the Shareholders of Cairn India Limited. Copy of the Letter is available at
http://www.sebi.gov.in/takeover/cairnlof.pdf (last visited on November 5, 2011).
9

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SEBI the put and call option arrangement along with the right of first
refusal are in illegal.
3.3.5

Further, SEBI provided an informal guidance to Vulcan Engineers Limited

whereby it clearly stated that a pre-agreed buy-back of shares through put
or call option is not valid under the SCRA.12 The grounds on which this
view was taken was the same as that in case of the public takeover of
Cairn India Limited.

4.

VALIDITY OF OPTIONS UNDER COMPANIES ACT

4.1

Before discussing the applicability of options under the Companies Act, let us
revisit the kinds of companies thereunder and applicability of the SCRA to such
companies:
4.1.1

Public companies
(i)
(ii)
(iii)

4.1.2
4.2

Private Companies

Public Companies
4.2.1

12

Public listed company

Public unlisted company
Private company which is a subsidiary of a public company
(Deemed Public Companies)

Section 111A of the Companies Act provides for a free transferability of

shares in case of a public company. While it is clear that the SCRA applies
to public listed companies, its applicability in case of public unlisted
companies has been strangely settled by judicial precedents. The Company
Law Board in the case of A.K. Menon v. Fairgrowth Financial Services
Ltd.13 held that:

See the SEBI Letter dated May 23, 2011 addressed to Vulcan Engineers Ltd. Copy of the Letter is
available at http://www.sebi.gov.in/informalguide/Vulcan/sebilettervulcan.pdf (last visited on November 5,
2011).
13
[1994] 81 Comp Cas 508 (Bom)

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(a)

The SCRA and the 1969 Notification also relates to unlisted

securities;

(b)

A security which is marketable is covered by the SCRA;

(c)

Marketable would mean any security which is freely transferable;

(d)

The SCRA provides for licensing of deals where there are no stock
exchanges, there, can be concluded that the legislative intent was to
extend applicability to the SCRA to unlisted securities.

4.2.2

In the BOI Finance case, there was no adjudication on the point of

applicability of the SCRA to public unlisted companies, but the Supreme
Court proceeded on the assumption of applicability of the SCRA.

4.2.3

Further, recently, SEBI in its Order Disposing of the Application Dated

April 7, 2010 Filed by MCX Stock Exchange Limited14 examined the
applicability of the SCRA to unlisted securities. Relying upon the BOI
Finance case and a decision of the Bombay High Court in case of Mysore
Fruit Products Ltd And Others v. The Custodian And Others15, SEBI held
that it is a settled legal position that buy-back (forward contracts)
arrangements in unlisted shares of public company are illegal under the
SCRA.

4.2.4

Even under the provisions of the Companies Act, the Courts have taken a
view that there can be no restriction on transferability of shares of a public
company. In the case of Western Maharashtra Development Corporation
v. Bajaj Auto Limited16, the Bombay High Court has held that Section
111A of the Companies Act mandates that there can be no restriction
whatsoever on the transferability of shares in a public company.
Consequently, an agreement granting a right of pre-emption in respect of
some such shares has been held as patently illegal. The Court further held

14

A copy of the order is available at www.sebi.gov.in/cmorder/MCXExchange.pdf (last visited on

November 5, 2011)
15
16

(2005) 107 Bom LR 955

Arbitration Petition No. 174 of 2006, decided on 15th February, 2010.

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that the effect of a clause of pre-emption is to impose a restriction on the
free transferability of the shares by subjecting the norms of transferability
laid down in Section 111A to a pre-emptive right created by the agreement
between the parties, which is impermissible.

4.3

4.2.5

Further, in the Balco Arbitration Award, the arbitration panel ruled that
the call option was in violation of Section 111A(2) of the Companies Act.

4.2.6

However, a contrary view was taken by the Division Bench of the Bombay
High Court in the case of Messer Holdings Limited v. Shyam
Madanmohan Ruia17. The Division Bench held that a private arrangement
between shareholders of a public limited company on a voluntary basis
relating to share transfer restrictions (right of first refusal) is not violative
of Section 111A of the Companies Act, 1956. The judgment also
suggested that it is not mandatory for the Company to be a party to such an
agreement relating to share transfer restrictions and it is not necessary to
incorporate share transfer restrictions in the articles of association of the
company.

4.2.7

Comfort maybe drawn from the fact that the position of restriction on
transferability of shares of a public company by way of inter-se
agreements has not yet been settled by the Supreme Court.

Deemed Public Companies

Since a Deemed Public Company and a private company have same provision
applicable to in terms on restrictions on transfer of shares (and, therefore, on the non
marketability of such shares), then unless otherwise construed by the courts, options
in shares of a Deemed Public Company also should be valid and legal and not be
affected by the provisions of SCRA and other notifications such as the 2000
Notification by SEBI.

4.4

17

Private companies

Appeal No. 855 of 2003 in the High Court of Bombay.

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4.4.1

Section 3(iii) of the Companies Act defines private company to mean a

company which by its Articles, restricts the right to transfer its shares, if
any, and limits the number of its shares to 50 (excepting employees and
ex-employees who were and are members of the company) and prohibits
any invitation to the public to subscribe for any shares in, or debentures of,
the company.

4.4.2

It is well known that unlike a private company, shares of a public company

are freely transferable. Further, since SCRA deals with marketable
securities, public listed companies directly come under the purview of
SCRA. The implications under SCRA are discussed below separately. The
question of applicability of SCRA to private companies was raised in the
case of Norman J Hamilton v. Umedbhai S. Patel18 where the Single Judge
of the Bombay High Court took a view that the scheme of the SCRA was
not intended to apply to the shares of a private limited company. The same
was held on the following grounds:
(a)

marketable security is one which enjoys a high degree of liquidity

and can be readily sold in the market; and

(b)

shares of a private limited company cannot be sold in the market;

The Division Bench upheld the above principle19. Hence, since private
companies are outside the scope of SCRA, the restrictions on put and call
options under SCRA are inapplicable to them.
4.4.3

18

19
20

However, it is pertinent to note the ruling of the Supreme Court to ensure

applicability of restriction on transferability of shares of a private
company. In the case of V.B. Rangaraj v. V.B. Gopalakrishnan20, the
Supreme Court held that a restriction to be binding on the company and
the shareholders shall be specified in the articles of association of a
company.

[1979] 49 Comp Cas 1 (Bom)

Dahiben Umedbhai Patel v. Norman J. Hamilton [1985] 57 Comp Cas 700 (Bom) (DB).
AIR 1992 SC 453, 1992 73 Comp Cas 201 (SC)

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5.

ANALYSIS OF VALIDITY OF PUT AND CALL OPTIONS

The views of SEBI and Courts on enforceability of put and call options and preemption rights which are common to a joint venture agreement (particularly share
purchase agreements) of companies which protect investor interest will have
impact on the future of mergers and acquisitions public companies in India.
However, in our opinion, there may be some grounds on which the views may be
rebuttable:

5.1

Intention of Regulators and analysis of judicial precedents

The judicial precedents, except the recent SEBI orders in case of Cairn India
Limited and Vulcan Engineers, have not dealt with options in securities. All
judgments in which the contracts were struck down as illegal, involved contracts
for the sale or purchase of securities and not options in securities. The distinction
between contracts for sale or purchase of securities and options in securities under
SCRA was clear by express prohibition on options in securities under the
erstwhile section 20 of the SCRA. This distinction was also recognized by the
Division Bench of the Calcutta High Court in the matter of East Indian Produce
Ltd. v. Naresh Acharya Bhaduri21.

5.2

SCRA seeks to restrict undesirable speculation in securities

It has been specifically expressed intention of the Regulators to restrict forward
contracts to prevent undesirable speculation in securities. Such speculation could
normally occur only when the securities are frequently traded, which is not the
case with unlisted securities where there is no market for trading. Therefore,
keeping in mind the purpose and object of the 1969 Notification issued by the
Central Government and the 2000 Notification issued by SEBI, it could be
concluded that the applicability of the SCRA was limited to listed securities.
Otherwise, even the genuine transactions, which are not speculative in nature
(such as option arrangements), would be struck off.

5.3
21

Whether grant of options amount to a contract

[1988]64 Comp Cas 259 (Cal)(DB)

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22
23

5.3.1

It may be argued that put and call option arrangements would become a
contract for sale or purchase of securities only when the contingency
(being the exercise of the put or call option) occurs and not merely by
grant of such options. Therefore, only such arrangement becomes a
contract (i.e. upon the exercise of the option), it is essential to be ensured
that contract is a spot delivery contract, i.e. the payment of consideration
and the delivery of securities is done either on the same day or the next
day as required under the SCRA.

5.3.2

The above argument may be further justified on the following grounds:

(a)

Under Section 31 of the Indian Contract Act, 1872 (Contract

Act), a contingent contract is defined to be a contract to do or not
to do something if some event collateral to such contract does or
does not happen. Therefore, it may be argued that an option may
not be a completed contract as it merely confers a right to sell or
purchase securities and may result in a contract for sale or purchase
or securities. Under Section 32 of the Contract Act, contracts which
are contingent on the happening of a future uncertain event cannot
be enforced by law unless and until that event taken place.

(b)

The High Court of Delhi in the case of Union of India v. Bharat

Engineering Corporation22 has held that a contingent contract is
unenforceable until the condition on which it depends is fulfilled.
Till then it is strictly not even a contract.

(c)

Further comfort may be drawn from the Calcutta High Court ruling
in the case of East Indian Produce Ltd. v. Naresh Acharya
Bhaduri23wherein the Division Bench held that the restriction on
spot delivery contracts applied to contracts for sale or purchase of
securities and not options in securities which were separately
prohibited under the erstwhile Section 20 of SCRA.

ILR 1977 Delhi 57

[1988]64 Comp. Cas. 259 (Cal)(DB)

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5.4

Exemption of collaboration agreements under the 1961 Notification

It may also be argued that option arrangements entered into between joint venture
partners would fall within the exception provided under the 1961 Notification and
therefore would be outside the ambit of the SCRA and consequently be legally
valid. However, it may be noted that the exemption provided under the 1961
Notification is available only in limited circumstances.

6.

CONCLUSION
It is pertinent to note that in 2010, India saw the largest increase in deal activity
among the big Asia-Pacific markets which was more than double as compared to
2009 and was calculated at US$9.5 billion, including venture capital,
infrastructure private equity investments and real estate investments.24 For any
such investments to be attracted to India and for India to continue with its growth
by drawing foreign investors, it needs to provide such foreign investors with
regulatory benefits. This is also because, exit is an important aspect of making an
investment and forms a much negotiated and concerned clause under any
Shareholders Agreement and making these provisions impermissible at the outset
would take out the substance of such an agreement.
We would like to highlight on the transactions where the foreign investors take
the risk at the time of exit by agreeing to exit at the fair market value of the shares
at the time of exit. If the intent of the put option is only to ensure the exit of a
shareholder or section of shareholders, it is merely a matter of private treaty
between shareholders. However, if a put option effectively works to guarantee a
lenders rate of return to an investor, it has the effect of transforming an
investment into a de facto loan, which may be defeating the distinction between
FDI and ECB under foreign exchange regulations. However, to hold the very put
option to be illegal may be anachronistic, as most derivatives are options, whether
a put or a call option should not make any difference. Considering the spread and
size of the global derivatives market, illegalizing options generically is like

24

Source: India Private Equity Report, 2011. Copy of the same can be obtained at
http://www.indiavca.org/IVCA%20Bain%20India%20Private%20Equity%20Report%202011.pdf. (last
visited on November 5, 2011)

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tarnishing the whole derivatives market in one sweep. We would, therefore, rather
contend that it is the use of options that may be challenged rather than put or call
options per se.