Globally, private equity and venture capital funds have gained prominence as the dominant forms of investment in companies. A natural corollary of the above has been the evolution of innovative and complex mechanisms designed to protect such investment and gain maximum returns on the same.
The first step in securing such investment is placing restrictions on transfer of shares that achieves the twin purposes of protecting investor money in case of further fundraising, event of liquidation, etc., while not unreasonably restraining the company from raising more investment. However, the successful realisation of such purpose is contingent on the effective enforcement of the rights granted to investors in lieu of their investment. It becomes imperative to have a cooperative regulatory and juridical landscape in place to enable investment.
Indian Courts, in this aspect are inclined to follow the established principle of party autonomy and the concomitant freedom of parties to contract. However, reasonable limitations have been placed, either through legislation or judicial precedent, to ensure that a balance is always maintained. One of the most pertinent restrictions is contained in Section 6 of the Indian Companies Act, 2013 (“Act“), which allows the Act to override any provisions contained in the Memorandum of Association, Articles of Association (“AoA“) or in any agreement or resolution, which is not harmonious with or is contrary to the provisions of the Act.
The discussion on investor rights and their protection was first evoked in V.B. Rangaraj Vs. V.B. Gopalakrishnan And Ors. (AIR1992SC453), which entrenched the principle that notwithstanding anything contained in the agreement between the parties, any restriction sought to be enforced on transfer of shares shall only be recognised if the same is duly incorporated in the AoA. Nevertheless, restrictions on transfer of shares, or the lack thereof, has an earlier point of reckoning than the AoA and that is, the type of company that is being invested in. A private company is bound to restrict transferability of its shares by law (as contained in Section 2(68) of the Act) wherein the shares of a public company are freely transferable.
Decisions which centre around the protection of investor rights thus invariably involve a deliberation on the distinction between transferability of shares in private and public companies. This is because of the applicability of a crucial piece of legislation called the Securities Contract (Regulation) Act, 1956 (“SCRA“). There has been some contention as to whether the provisions of the SCRA are applicable to private companies, however a slew of cases, most famously, Dahiben Umedbhai Patel And Ors. Vs. Norman James Hamilton And Ors (1983(85)BOMLR275), held that since the securities of a private company do not possess the ‘character of liquidity’ and are not ‘marketable securities’ as per the definition of ‘securities’ contained in Section 2(h)(i) of the SCRA, the provisions of the SCRA would not encapsulate private companies. The above judgement was upheld by the Supreme Court in 2013 in the case of Bhagwati Developers Private Limited Vs. Peerless General Finance and Investment Company Limited And Ors. ((2013)7SCR547). The Apex Court affirmed that the definition of ‘securities’ in the SCRA did not envisage securities issued by private companies “notwithstanding the use of words ‘any incorporated company or other body corporate’ in the definition.” It further clarified that the shares of a public unlisted company shall also be subject to the provisions of the SCRA.
Strategically, one of the most significant rights for the investors are exit rights. These rights are inserted in agreements as ‘options’, namely ‘put options’ and ‘call options’ and are purely contractual arrangements. A put option is the investor’s right to sell its shares on occurrence of a pre-defined event at a valuation agreed between the parties. While there is no restriction on the insertion of such exit clauses in other agreements under Indian law, the Reserve Bank of India does not permit the insertion of an optionality clause in an agreement between an Indian company and foreign investor which would guarantee assured returns to such foreign investor on their exit as that would be in violation of the Foreign Exchange Management Act, 1999.
A recent judgment from the Bombay High Court has provided much needed clarity to investors looking to exercise their contractual rights. In Edelweiss Financial Services Limited Vs Percept Finserve Private Limited And Ors. (Arbitration Petition No. 220 of 2014), the Court upheld the validity of the put option guaranteed to Edelweiss under the Share Purchase Agreement (“SPA“) executed between Edelweiss and Percept in December 2007. Under the put option, Edelweiss had the right to: (i) re-sell the shares to Percept on such price as would give Edelweiss an internal rate of return (IRR) of 10% (ten percent); or (ii) to continue to hold such shares subject to certain undertakings from Percept, in case of a breach of the SPA. Section 16 of the SCRA read with the Securities and Exchange Board of India’s circular dated March 1, 2000 prohibits ‘forward’ contracts, i.e. those contracts in which the delivery of the shares and payment for the same are not contemporaneous. Percept argued that the repurchase of shares in the future as envisaged under the SPA constituted a derivative which, if not falling under Section 18-A of the SCRA was prohibited since Section 18-A explicitly states that contracts in derivative are valid and legal only if traded on a recognised stock exchange.
The Court rejected the reasoning put forth by Percept and distinguished put option contracts as being spot delivery contracts, which are defined under Section 2(i) of the SCRA and therefore permitted under the same regime. These are contracts in which the price for the shares is paid simultaneously with the delivery of such shares. The Court held that a put option is enforceable as the contract of sale comes into existence only after the exercise of such option, thus clearly removing it from the ambit of forward contracts. Therefore, the Court held that such an option was neither a forward contract nor a contract in derivative falling under Section 2(ac) of the SCRA and instead fell squarely within the definition of ‘spot delivery contracts.’ The contract comes into being, if at all, at a future point of time, when two conditions are satisfied, namely: (i) failure of promoter to restructure within stipulated time; and (ii) exercise by Edelweiss of its option to require repurchase by promoter upon such failure. It also held that the put option cannot be said to be a forward contract merely because promoter was given some time to repurchase after the exercise of put option. There was nothing to suggest that there is any time lag between payment and delivery of shares or whether shares would be delivered first, and price would be paid later or vice versa.
It can be averred that the current legal regime is not averse to the idea of enforcement of contractual rights of investors, provided that such rights fall within the contours of reasonableness and do not fall foul of the provisions of the applicable legal provisions.