No harm, no foul?: The Bombay High Court’s rescue of vanilla exit options

Investments into unlisted public companies that provided guaranteed exits, at least until 2013, were plagued by questions as to their validity and enforceability.  Aside from the uncertainty as to whether unlisted securities were governed by the Regulation Act, the investor community had to deal with the blanket prohibition on contracts that did not qualify as “spot deliveries” under the SEBI’s regulatory framework.

The Bombay High Court in Banyan Tree Growth Capital LLC v. Axiom Cordages Limited,[1] ruled that the Regulation Act did not apply to fixed-return put options negotiated at the time of the original investment, with a view to secure exits.  In coming to that conclusion, the Court offered four primary justifications:

1. contracts that were not “speculative” in nature were not governed by the Regulation Act, so much so that speculation was “the primary factor to consider [in the legislation’s] applicability”;

2. the benefit of relaxations for put options introduced in 2013, ought to be extended to contracts entered into prior to the relaxation, and failing to do so would result in an “anomalous” situation

3. there was never an express bar on put options in shareholders’ agreement; and

4. perhaps most importantly, an option was a mere privilege, and until exercised, no “contract” for sale and purchase of securities, regulated by the Regulation Act, would come into existence.

The ruling of the Court is almost entirely founded on the intent of the legislation and, as even the Court recognised, did not conform to a strict textual interpretation.  As a result, some doubts linger.  The Court effectively conferred retrospective effect to the relaxations instituted by SEBI in 2013, arguably at odds with the text of the law.  The finding that put options are not “contracts” until exercised, and hence not regulated, perhaps not only overlooks the fact that the Regulation Act defines “options in securities” as “contract[s] for the purchase or sale of a right to buy or sell, or a right to buy and sell, securities in future”, but also begs the question why SEBI felt the need to institute a limited dispensation for options in 2013, conditioned on a number of requirements.

There are however aspects to the decision that help tide over practical difficulties that investors have faced, particularly the preference to preserve the bilateral essence of options, instead of being compelled to include them in shareholders’ agreements.  In upholding an option contained in a distinct put option deed, the Court, guided by its purposive interpretation, appears to have extended the benefit of the 2013 dispensation to options contained in documents other than shareholders’ agreements, provided such documents are demonstrably linked to a contemporaneous investment in the portfolio company, “enabling the investor to secure the debt/financial assistance, by providing an agreeable form of security, by offering subscription to the shares/debentures”.

While it remains to be seen if this decision will continue to hold the field, it nevertheless achieves for investors an outcome that cuts through repeated attempts by promoters and investee companies to wriggle out of contractual commitments made at the time of receiving an investment.  Indeed, a series of decisions, particularly under Indian exchange control, has laid to rest the notion that promoters could be rightfully allowed to plead invalidity of contracts when, to quote the Delhi High Court, it would be “plainly dishonest” for them to have represented, at the time of receiving the investment, that those very obligations were valid and binding.  For now, investors would want to incorporate as many elements from the Court’s reasoning in Banyan Tree into drafting put option clauses, and to speak particularly to the parties’ intent to secure the investment, as opposed to speculation.

Authors:

Vydyanathan L, Associate
Arushi Dikshit, Associate

Footnote:
[1] Judgment dated April 30, 2020 in Commercial Arbitration Petition No. 476 of 2019

Date: August 11, 2020