INTRODUCTION

The Indian corporate environment is characterized by its volatile mix of opportunities, aspiration and complex regulatory frameworks especially with the country's emerging status as one of the largest markets globally. With numerous opportunities, it has attracted a significant number of foreign investments, especially through acquisitions and joint ventures (JVs).

Foreign companies, entering into JVs or acquisitions, often face challenges due to India’s complex regulatory environment that may affect their operations. To mitigate these risks, exit clauses are a critical element in such JV agreements, as they provide a clear roadmap for foreign partners wishing to divest or exit the business.

Put options, being one of the exit options, enable investors to sell their shares to the issuing company or other shareholders at a set price within a stipulated period, allowing shareholders to define their exit strategy clearly. By clearly defining the terms under which a foreign partner can exit the joint venture, these clauses help manage the inherent uncertainty of the Indian market, providing foreign entities with a more favorable environment to engage in business partnerships while balancing risks and returns. Hence, a put-on option allows the put buyer to exercise the option within the designated expiration time at a predetermined price Such clauses are vital in fostering trust between local and foreign partners, ensuring that the latter have an exit strategy in place, which enhances the overall attractiveness of India as a destination for foreign direct investment (FDI).

PUT OPTION:  A SWORD AND SHIELD

A put option gives the holder the power to sell an asset at a pre-determined price within a specified timeframe. The duality of this instrument makes it constraining: it works as both a defensive shield (limiting downside risks) and a strategic sword (leveraging power in negotiations).

However, it is important to emphasize that exercising the put option by a foreign partner also involves various legal, regulatory, and administrative issues challenges related to the enforcement of such clauses. These issues must be carefully considered when drafting the definitive agreements or invoking these options in cross-border contexts.

Since India is an exchange-controlled state, the framework and regulations of Foreign Exchange Management Act, 1999 (FEMA) govern transactions between residents and non-residents. Foreign Exchange Management Act (FEMA) plays a crucial role in ensuring compliance with the FDI framework, particularly concerning the transfer of equity from international investors to Indian enterprises to ensure that any such transfers align with valuation norms and adhere to the sectoral caps set by the FDI policy. A key challenge for foreign investors lies in share valuation, as FEMA requires the sale to occur at fair market value. This can create complications when executing the put option, especially if the parties disagree on the share price.

Traditionally, put options were considered speculative instruments since their performance depended on future events. Under the Securities Contract Regulation Act of 1956 (SCRA), such options were deemed invalid because they did not come under any of the definitions for spot delivery or derivative contracts. The legal position was clarified when SEBI issued a notification on October 3, 2013 for the first time permitting contracts in shareholders agreements or provisions in the articles of association, providing for a put/ call option. The October 2013 Notification permitted put/call option clauses subject to satisfaction of the underlying conditions which included compliance with FEMA. The latest judgment of a Division Bench of the Bombay High Court, in Percept Finserve Private Limited v. Edelweiss Financial Services Limited upheld the enforceability of a put option clause in a share purchase agreement, that was executed prior to the October 2013 Notification.

Moreover, concerning Foreign Exchange Management Act of 1999 (FEMA), put options that give assured returns to investors were considered a contravention of regulations that forbid guaranteed returns on investments.

In numerous cases, the Court upheld the put option while requiring RBI permission for the remittance. The Bombay High Court's decision in Videocon Industries Ltd. v. Intesa Saupaolo SPA[1] "interpreted the phrase with the general or special permission of the Reserve Bank of India as not requiring prior permission and stated that contracts were not invalid for lack of permission. A public interest lawsuit was brought in the Calcutta High Court in Sanjib Kumar Dan v. Union of India and Ors [2]to clarify that guaranteed returns on equity investments are unlawful. The court denied the petition, which upheld the existence of adequate rules.

In this regard, the case of “NTT Docomo V. Tata Sons” is a landmark judgment which is more than a legal dispute between two corporate giants, revolving around breach of a shareholder agreement related to the sale of shares in the Indian telecom company Tata Teleservices. The case helps in exploring the broader context of corporate governance practices in India along with the significant legal, strategic, and financial ramifications. The case revealed that put options, when partnered with contractual obligations, serves more than just financial hedges but they also become tools for enforcing accountability in joint ventures and safeguarding investments in unpredictable market.

Exercising put options in a complex legal framework

As one of the world’s most promising investment destinations, India attracts foreign investors eager to stake their claim. Regardless, for these shareholders, particularly those entering through acquisitions or joint ventures (JV’s), the Indian regulatory framework often complicates otherwise straightforward financial strategies. Among these complexities lies the issue of put options, a simple seeming contractual mechanism that becomes entangled in a legal and regulatory hurdle when exercised in India.  While offering a crucial exit strategy for investors, the put options open up the labyrinth of valuation norms, compliance mandates, and judicial scrutiny for foreign shareholder. The most immediate challenge foreign shareholders face is the compliance burden imposed by Indian regulations:

FEMA’s Valuation Norms: FEMA mandates that the transfer of shares must be at or above the fair market value for foreign investors selling to residents. However, this requirement often clashes with the predetermined pricing in a put option. In the case the agreed upon price is below the fair market value, the transaction maybe deemed non-compliant, leaving the foreign investor in a precarious position.

Sectoral Caps and Restrictions: FEMA also governs sector-specific FDI caps. For instance, investments in susceptible sectors like defense or telecommunications face additional scrutiny, making the exercise of put options even more complicated.

Foreign investors frequently encounter delays in obtaining the necessary regulatory approvals:

Exercising a put option in India often triggers tax implications that can erode the financial benefits of the transaction:

Indian courts have played a pivotal role in shaping the enforceability of put options, but they also highlight the challenge investors face:

The cornerstone of navigating the legal framework is a well-drafted shareholder agreement. Foreign investors must anticipate potential challenges and craft agreements that:

CONCLUSION

While India offers immense potential for foreign investors, the exercise of put option remains a complex and nuanced process. At its core, the put option represents a delicate balancing Act between safeguarding investor rights and ensuring compliance with India’s evolving legal framework. The requirement to adhere to FEMA’s valuation norms, navigate sectoral caps, and secure RBI permissions reflects the complexities of operating in an exchange-controlled system. While these measures are designed to preserve market integrity and align with public policy, they also demand that investors remain vigilant, informed, and pro-active in structuring their agreements and business strategies.

Despite these challenges, the future hold promises. India’s legal and regulatory environment is gradually maturing, with reforms aimed at creating a more predictable and investor friendly ecosystem. SEBI’s notifications, judicial clarity, and the governments ongoing efforts to streamline FDI policies are all steps in the right direction. These developments reflect India’s recognition of the critical role foreign investment plays in its economic growth story. For foreign shareholders, the path forward requires a combination of legal expertise, strategic foresight, and a willingness to embrace the intricacies of India’s regulatory framework. Success lies in understanding the markets unique challenges and leveraging its opportunities. Exercising put options, though complex, can be a powerful tool when wielded with preparation and precision.

India remains a land of immense potential for foreign investors, offering opportunities that are as vast as its regulatory landscape is intricate. The put option, once seen as a speculative gamble, now stands as a symbol of India’s evolving approach to business partnerships. By, rising to meet the challenges of this framework, foreign shareholders not only safeguard their investments but also contribute to a more robust and globally integrated Indian economy.

Author: Ms. Jyotsna Chaturvedi, Head – Corporate Practice.

Footnotes

[1] Intesa Sanpaolo S.P.A vs Videocon Industries Limited on 5 December, 2013 available at https://indiankanoon.org/doc/19525454/

[2]Sanjib Kumar Das vs Union Of India & Ors on 10 September, 2021 available at  https://indiankanoon.org/doc/98831369/