Red signals on put options turned yellow, soon green?

Not long ago, the validity and enforceability of put options on equity shares and compulsorily convertible debentures and preference shares held by foreign investors, being one of the preferred exit routes, was the biggest bone of contention between the proponents of foreign direct investment (FDI) and India’s securities and foreign exchange regulators. The Reserve Bank of India (RBI) on 3 February this year has announced its intention to allow investors an assured return at an appropriate discount over the sovereign yield curve through an embedded optionality clause or otherwise. The recent and rapid liberalization of the regulatory regime on this issue is briefly traced below.

Regulatory clampdown

The Securities and Exchange Board of India (SEBI), through its notification dated 1 March 2000, prohibited contracts for sale or purchase of securities, other than by spot delivery or such other contracts as expressly permitted. As per SEBI, private contractual arrangements granting options were forward contracts and hence transgressed the Securities Contracts (Regulation) Act, 1956, which permits certain specified forward contracts entered on stock exchanges.

The RBI, on the other hand, frowned on FDI instruments with options and assured returns from promoters, as being akin to external commercial borrowings (ECBs) and not equity and hence a mode of circumventing the stringent regulatory regime governing ECBs. In a circular dated 8 June 2007, the RBI stated that instruments which are redeemable or optionally redeemable qualify as ECBs and cannot fall within the purview of the FDI regime.

The RBI’s stance was expressed on a case-to-case basis until the Department of Industrial Policy and Promotion (DIPP) introduced a prohibition on options in the consolidated FDI policy of 1 October 2011. However, in light of severe criticism from the industry, the provision was deleted within a month of its publication.

Vidyut Gulati is a partner and Kushal Sinha is an associate at Shardul Amarchand Mangaldas & Co. The views expressed in this article are those of the authors and do not reflect the position of the firm.