Sebi moves to put contract law in sync with times
Given that most shareholders would like to have agreements with clauses to protect minority rights, or to buy/sell partners at a later date, it was never clear why the government never allowed them. One argument was that such agreements camouflaged debt as equity. If Company A owns 26 % shares in Company B and Company C—which owns 74 % of B—has a call option, it is possible to argue A is just a front for C which has probably even funded the purchase of A’s shares. Since the law, in many sectors such as telecom, requires a 26% Indian shareholding, such deals are not unheard of. But then why have a law which makes such a formality necessary? While the law never allowed such call and put options, what’s interesting is that when the NDA government sold shares of Balco and Hindustan Zinc to Sterlite Industries, it gave Sterlite a call option which allowed it to buy the government’s residual stake in these firms at a pre-determined price. Why the NDA entered into such a contract when the law didn’t allow it is not clear; nor is it clear why, after the contract was signed, the law wasn’t amended to make such contracts legal. Anyway, when the time came to honour the call, the government had changed and the UPA refused to allow the residual stake sale. Sterlite never went to court to press for its rights, presumably because taking on a government isn’t the brightest thing for a running business.
If the issue was restricted to Anil Agarwal, it may not have mattered that much, but such clauses are pretty much standard in most private equity contracts for instance—$15 billion of private equity money was invested in India between January 2012 and August 2013. Nor is it just PE agreements, several JVs that Indian and foreign firms have signed have such options—if an investee firm does not generate certain returns, for instance, the investor firm can have a put option to allow it to cash out at a pre-determined price. Some foreign insurance firms would have liked to own 51% of their Indian JVs but are prevented from doing so because of the law—several of their agreements have right-of-first-refusal clauses. Of course, it is not clear how such contracts were to be enforced if the Indian law didn’t allow them, though one possibility is if both parties are registered overseas such clauses can be built in. Indeed, the authorities were turning a blind eye to such contracts until the MCX-SX case where Sebi started looking into them carefully since it suspected MCX-SX’s promoters were tying to circumvent the 5% shareholding limit by selling shares with put options.
While this has been fixed, overseas investors will have a bit of a wait since RBI is yet to issue the necessary follow-on notification. Right now, if any investment contract has such clauses, RBI treats the inflows as debt, not equity. While giving legal recognition to options ensures India is now on par with the rest of the world, the fact that such contracts have to be settled by actual delivery of the underlying securities suggests India is still uncomfortable with the idea of what is still regarded as naked speculation.