Generally speaking the investment agreements have provisions wherein the promoters/founders are obligated to facilitate an exit for the investors upon occurrence of certain trigger events. For example, in case of material breach of the obligations, the investor shall have the right to put their shares to the promoter at a commercially agreed premium amount. This is one of the provisions under which the investors seek to secure their exit in case they are not satisfied with the Company’s growth or performance which is represented by the promoters. This article seeks to discuss and analyse the validity of ‘put options’ in investment agreements under Indian laws.
Provisions Under The Indian Contract Act (ICA)
Section 73 of the ICA states as under:
“When a contract has been broken, the party who suffers by such breach is entitled to receive, from the party who has broken the contract, compensation for any loss or damage caused to him thereby, which naturally arose in the usual course of things from such breach, or which the parties knew, when they made the contract, to be likely to result from the breach of it.”
Accordingly, the ICA gives a legal right to claim damages in case of breach of contract.
Provisions Under The FEMA Regulations
When the promoters of Indian companies purchase shares from a foreign investor, then such transfer amounts to transfer of shares from a non-resident to a resident and is required to comply with the foreign exchange laws. Currently the foreign exchange laws are governed by the Foreign Exchange Management Act, 1999 (FEMA)
Rule 21 (2) (c) of the Foreign Exchange Management (Non-debt Instruments) Rules, 2019 (NDI Rules) specifically provides that transfer of shares from a non-resident to a resident cannot be at a price higher than the fair market value of equity instruments. The provision states as under:
“21 (2) (c) transferred by a person resident outside India to a person resident in India shall not exceed:
(iii) the valuation of equity instruments done as per any internationally accepted pricing methodology for valuation on an arm’s length basis duly certified by a Chartered Accountant or a Merchant Banker registered with the Securities and Exchange Board of India or a practising Cost Accountant, in case of an unlisted Indian company.”
Hence, if ‘put options’ clauses provide for a premium to the fair market value for a transfer from a non-resident to a resident then this rule expressly restricts the same.
Secondly, the NDI Rules also restricts assured returns specifically to foreign investors. This stems from the principle that an investor in an equity instrument invests with an inherent risk component and hence cannot be guaranteed an assured return similar to debt instruments. This provision has been provided in the form of an explanation under NDI Rules which states:
“The guiding principle shall be that the person resident outside India is not guaranteed any assured exit price at the time of making such investment or agreement and shall exit at the price prevailing at the time of exit”.
It becomes evident from the foregoing that a foreign investor cannot be entitled to an assured return at the time of exit, and that the consideration to be received by the foreign investor upon exercising the ‘put option’ cannot exceed the fair value of the shares at that given point in time.
The above-mentioned restrictions have been there in FEMA under the erstwhile Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2000 (TISPRO) as well. However, the Tata Docomo case brings out an interesting way in which an Indian promoter and a foreign investor can enforce these regulations.
Under the investment agreement, Docomo was assured to receive either the fair value of the shares as of 31 March 2014 or 50% of the price at which Docomo purchased its shares, whichever was higher. The Delhi High Court interpreted this clause to state that these provisions do not strictly provide an assured return but act as a downward protection, which can be an acceptable commercial understanding arrived between the parties. The Court was also cognizant of the fact that if such downward protection clauses are also struck down then the foreign investments in India may take a hit and that our strategic relationship with Japan in relation to foreign direct investment (FDI) inflows may also be put at a risk. Accordingly, the Court interpreted the ‘put option’ as a pre-determined damage claim for breach of obligations under the investment agreement.
In the case of Shakti Nath vs Alpha Tiger Cyprus Investments, the Delhi High Court ruled that it was not against RBI rules to award damages to foreign investors for breach of an investment agreement. The court determined that there was no violation of RBI regulations since demanding damages under Section 73 of the Contract Act, 1872, was not the same as exercising the ‘put option’.
Our Comments
While the aforesaid discussed judgements provide an alternate method to enforce ‘put options’, these provisions continue to remain under the FEMA which is stringent and does not take into account the prevailing market practice.
Therefore, the current regulatory hurdle that exists under FEMA which restricts assured return causes investors to take recourse to arbitration in order to claim damages which is costly, time consuming, affects ease of doing business in India and may even discourage foreign direct investment in India. Given the same, the current regulatory framework needs to be relooked and aligned with the industry norms.
Authors: Abhishek Kale, Manish Parmar, Niyati Shroff & Shikha Modi