Options in shares: a clear investment option?

The legality of put and call options in India is a subject of intense speculation. It became the subject of controversy when the Department of Industrial Policy and Promotion (DIPP) recently treated ‘in-built options of any type’ as debt; not permissible as foreign direct investment, only to delete the investor-offending phrase without much ado, a few days later.

Typically, put and call options (and their hybrid varieties, such as tag along and drag along rights) are structured into investment agreements to allow for exits to parties in the future. They afford comfort to investors, both foreign and domestic, and are seldom intended to be speculative transactions in this context.

The attempt by the DIPP to ban options in shares raised two rather uncomfortable issues: first, are options in equity shares loans masquerading as equity? And secondly, how enforceable are contracts in options anyway? While the first issue is not an immediate cause for concern, the DIPP did highlight the age-old quandary over the latter question in its regulatory flip-flop in 2011. This article therefore briefly discusses whether put and call options are forward contracts, and relies on the recent decision of the Division Bench of the Bombay High Court in MCX Stock Exchange Ltd v Securities and Exchange Board of India & ors [2012], to conclude that options are not forward contracts and to that limited extent do not violate the Securities Contracts Regulation Act (SCRA) 1956.

The regulatory framework

The regulation of options is one subject of SCRA 1956, which intended to prevent undesirable transactions in securities. Sections 13-20 of SCRA 1956 regulate ‘contracts and options in securities’.

Section 13 of SCRA 1956 empowered the government to regulate, by notification, certain contracts in securities conducted other than through a stock exchange. In 1969 therefore, the central government declared, by notification, that contracts for the sale or purchase of securities other than ‘spot delivery contracts’ or contracts for cash, hand delivery or special delivery in any securities as prescribed, required its prior approval.

Since spot delivery contracts are defined as contracts that provide for actual delivery of securities and the payment of a price for them either on the same day of the contract or the next day, it seemed that contracts in options that were not settled on the same day or the next day would also be curtailed. In any event, s20 of SCRA 1956 expressly declared all options in securities as ‘illegal’.

In 1995, however, s20 was deleted by the Securities Laws (Amendment) Act 1995. The statement of objects and reasons of the Securities Laws (Amendment) Bill 1995 provided that, in order to enable the Securities and Exchanges Board of India (SEBI) to function more effectively, it was considered necessary to amend SCRA 1956 ‘to facilitate the issuance and trading of options in securities’. This deletion reflected a clear policy change; towards one that implicitly allowed options. Notably the preamble to SCRA 1956 was also amended to delete the prohibition of options from the purview of activities regulated by SCRA 1956. However, other provisions of SCRA 1956 and the actions of various regulatory authorities interpreting it (most importantly the SEBI) failed to fall in line with the aforesaid stated intent of the parliament, and this continued to cause ambiguity.

On 1 March 2000, the 1969 notification was repealed, only to be replaced by a notification issued by the SEBI on the same day, which provided inter alia 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…’

It seemed therefore that, though the illegality of options was deleted from the statute books, by delegated legislation the SEBI (now empowered to administer SCRA 1956) had proscribed options yet again. And consistently so, the SEBI has argued, relying predominantly on two arguments, that options are unenforceable.

The SEBI argued, based on s18A of SCRA 1956 (which provides that contracts in derivatives are legal and valid if traded on a recognised stock exchange and settled on the clearing house of a recognised stock exchange), that options are derivatives. Consequently, it argued that, since options derive their value from underlying shares, if structured into agreements inter se parties in an over-the-counter format and not traded on a stock exchange, they violate s18A. It also argued that options are contracts in securities not amounting to spot delivery contracts and are akin to forwards or futures, and are therefore invalid under SCRA 1956 unless undertaken on the stock exchange. Though execution of contracts in options outside the territorial jurisdiction of SCRA 1956 was considered a workaround, a more nuanced counter-argument was essential to uplift investor confidence.

The SEBI’s arguments are in fact rebuttable on several grounds, other than on account of the legal sanction provided to options by way of various amendments to SCRA 1956.

First, there is a distinction between ‘options’ on the one hand and forward contracts. A ‘contract’ is defined under SCRA 1956 as a ‘contract for or relating to the purchase or sale of securities’. SCRA 1956 defines an ‘option in securities’ as 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 includes a teji, a mandi, a tejimandi, a galli, a put, a call or a put and call in securities’. The emphasis in the second definition is on the purchase or sale of a mere right whereas in a contract simpliciter, there is directly a purchase or sale of securities. An option in securities merely confers a right to sell or purchase securities and no obligation on the option holder. Till such time that the option is exercised, the contract is a ‘contingent contract’. And when such option is exercised to the extent the transfer is completed within the stipulated time period of 24 hours, it should qualify as a spot delivery contract and thus, allowed under SCRA 1956.

Juxtaposed to this, a forward contract is treated as a right exercisable at a future date to buy or sell shares at a contracted price. It is therefore a contract to purchase securities with the preconditions of a fixed price and lapse of time. It is not contingent upon the act of any party to the contract, and would therefore qualify upon execution itself as a contract prohibited by SCRA 1956 and the SEBI notification of 2000.

Even though judicial recognition has been provided to an option as being a contingent contract that becomes a complete and valid contract only when the option is exercised, such recognition was accorded by the Bombay High Court in Jethalal C Thakkar v R N Kapur [1956] under the Bombay Securities Contracts Control Act 1925 and not SCRA 1956. The Thakkar decision was therefore not accepted by the Bombay High Court in Niskalp Investments and Trading Co Ltd v Hinduja TMT Ltd [2007] wherein the Court rejected the approach in Thakkar as it did not deal with SCRA 1956. Notably, the Thakkar decision came from a division bench of the Bombay High Court, while the Niskalp decision was rendered on a summons for judgment in a summary suit where unconditional leave to defend was granted without advancing the discourse.

Secondly, as argued in MCX, the legality of options is implicitly recognised under the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations 2011 as well as the predecessor regulations of 2007, since it presupposes a private negotiated arrangement to buy or sell, contingent upon the successful completion of an open offer process thereunder. Such a private negotiated arrangement cannot be concluded under the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations 2011 or the predecessor regulations of 2007, other than as options in shares.

Better late than never: the MCX decision

As if the SEBI’s constant position that options were illegal was not enough to get investors jittery, the DIPP, with its vacillation over the options issue, made matters worse. The stage was set therefore for a clear and decisive policy on the enforceability of options. It was in this background that the MCX decision was rendered on whether the SEBI was right in terming an option to acquire shares at a future date as invalid under SCRA 1956.

While the SEBI argued that options were derivative contracts incapable of being executed over-the-counter under s18A of SCRA 1956, the court did not consider this contention as it was raised for the first time only during oral arguments. However, it held that options are not contracts for the sale and purchase of shares, unlike forward contracts. It held that SCRA 1956 proscribes forward contracts and that options are contingent contracts more in the nature of a privilege. This privilege grants discretion to a person to utilise the right under the option, but there is no reciprocal set of rights and obligations created like under a contract. Once exercised, an option could be completed by spot delivery, which is lawful under SCRA 1956.

India’s investment climate would have admittedly suffered a setback had MCX rendered options patently illegal. Even though the MCX decision is appealable, it must be applauded for two reasons: first, its lucid exclusion of options in shares from the purview of forward contracts and secondly, not having dampened investors’ spirits in India beyond repair. That being said, a decision on whether options offended s18A of SCRA 1956 would have laid to rest long, drawn-out controversy.