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Enforceability of Put Option in Shareholders Agreement or a Share Subscription

Agreement

For a clearer understanding the meaning of “Put Option” is required to be probed into.
A “Put Option” as understood in common parlance is an option to sell. A “Put Option” is
an Investor’s exit/liquidity option by way of which an Investor can, on the happening of a
“Put Trigger” event, compel the promoter/ shareholder of Company to buy its shares
either wholly or partly, at a valuation, agreed between the parties. A “Put Option” has
become a popular exit option in business practice and has found expression by way was a
“Put Option” Clause in Share Holders Agreement (SSA) or Share Subscription
Agreements (SHA). This right to sell is not vested in a shareholder by way of law but is a
creation of contractual arrangement between the parties. Thus if “Put Option” is not
provided in the SSA or SHA then the investor/ shareholder cannot exercise such right to
sell.

The only way the legality of Put Option can be questioned is whether a contract which
provides an option to the Investor to sell his shares to the Promoter at a consideration
fixed on a date where the performance is to be done on a later date, amounts to a
“forward contract” which is prohibited under Securities Regulation Act, 1956.

For a comprehensive understanding of this issue the concepts “restriction on transfer of


shares”, meaning of “forward contract”, meaning of “spot delivery contract”,
“applicability of SCRA to private limited companies, listed public limited companies,
unlisted public limited companies”, is required to be probed into.

For the convenience of presentation this issue is dealt from the perspective of a) Private
Limited Companies, b) Listed Public Limited Companies, and c) Unlisted Public Limited
Companies.

1.1 Legality of Put Option in Share Subscription Agreement and Share Holders
Agreement of Private Limited Companies.
One of the requirements as envisaged in the meaning of Private Limited Companies is
that there must be some restriction on the transferability of shares. It has always been
agreed by the Courts that the restriction upon transfer of shares means any restriction on
the transfer of shares which will give some control to the Company over transferability .
The restriction must apply to all shares and to classes of shares and not to some shares or
classes of shares only. No shares can be free from transfer restrictions.

The only permissible restrictions on transferability of shares are those contained in the
company’s article of association. An additional restriction not contained in the articles
but in a private agreement between two shareholders which places further obstacles in
way of transferability is not binding on either the company or the shareholders

Thus a promoter can be restricted from transferring his shares in a private limited
company by way of a private agreement i.e. an SSA or SHA or SSA cum SHA which
contains restrictive clauses like “ Put Option”, “Tag Option”, “Drag Option”. However
care should be taken that the provisions of the private agreement are incorporated the
AOA of the company.

Further Securities Contract (Regulation) Act, 1956, does not apply to Private Limited
Companies. This has been held in catena of judgments. In Dahiben Umedbhai Patel and
others v. Norman James Hamilton and others it was held that shares of a private limited
company were not marketable securities as defined in Section 2(h) of the SCRA. The
learned Judge observed that a marketable security is one which enjoys a higher degree of
liquidity and must, therefore, be such that it can be readily sold in the market and since
the shares of a private limited company cannot be sold and also cannot be listed in the
stock exchanges because one of the basic requirement of the listing of shares is that the
shares must be freely transferable. Since the shares of private limited company are not
freely transferable therefore it does not come under the purview of SCRA as the purpose
of the Act was to control securities which were normally dealt on the stock exchange, that
is to say Public Limited Companies.

Thus since SCRA has no application to the Private Limited Companies a private
company can enter into forward transactions of shares.

1.2 Legality of Put Option in SSA and SHA of Listed and Unlisted Public Limited
Companies.
Free transferability of shares of public companies is a great beneficial feature of
incorporation. It ensures permanent capital to the company, while at the same time
ensuring liquidity of the shareholder’s investment. The shares of public companies are
made generally freely transferable without there being any need for taking permission
from the company or any other agency. To facilitate this, shares or any other interest of a
shareholder in a company has been declared by law as a movable property, transferable in
the manner provided by the Articles of Association of the company; vide section 82 of
the Companies Act, 1956. While free transferability was thus assured, till recently the
companies were permitted to place reasonable restrictions on transferability of shares in
their Articles subject to the condition that a company could not completely prohibit the
transfer of shares, as the law itself had given the right of such transfer. Similarly, the
Articles could not impose some onerous terms which would make the right of transfer an
illusory right.

The Companies Act did not restrict the grounds on which a company could refuse to
register a transfer of shares. However, in the case of listed companies, the Board of
Directors could refuse to register a transfer on only one or more of the four grounds
mentioned in section 22A of the Securities Contracts (Regulation) Act, 1956.

Further it was common for the companies to provide in their Articles that the Directors
could at their absolute and uncontrolled discretion decline to register any transfer of
shares.

Thus the legal position till recently has been that while shares of a listed public company
were generally transferable freely, the companies were allowed to provide in their
Articles power to their Boards to refuse the registration of the transfer of shares on the
grounds mentioned in section 22A of the Securities Contract (Regulation) Act. In view of
the aforementioned judgments, this power of refusal of shares had to be exercised in a
bona fide manner in the interest of the company and the general body of shareholders. An
aggrieved transferee of shares was entitled to appeal against the refusal of the company to
transfer of shares to the company Law Board under section 111 of the Companies Act.

However, this legal position has changed with the depository system coming into
existence. The Depositories Act, 1996 has changed this position in the following manner:
• A new section 111A has been inserted in the Companies Act, which shows that the
shares (or debentures) of a public company, and any interest therein, shall be freely
transferable.

• Section 22A of the Securities Contract (Regulation) Act which inter alia specified the
grounds for the refusal of registration of transfer of shares by a company has been
omitted completely.

• By inserting subsection (14) in section 111 of the Companies Act, it is now provided
that the power to refuse registration of transfer of shares and appeal against such refusal,
shall be applicable only to the private companies. Thus, public companies have no power
to refuse registration.

• Due to newly inserted subsection (3) in section 108 of the companies Act, transfer of
shares can now take place between a transferor and transferee directly in the records of
the depository without following the detailed procedure under section 108 (of submitting
transfer form, etc.) if both of them are entered as beneficial owners in the records of a
depository.

• Other consequential changes have been made through section 41(3) of the Companies
Act, section 10 of the Depositories Act, etc.

In view of these changes in the relevant laws, it is clear that the shares of a public
company have now been made freely transferable fully. In fact, where the shares of a
public company have been dematerialized, the transfer of such shares takes place in the
records of the depository itself, without there being any need to make a reference to the
company or its registrar. The depository is required under section 13 of the Depositories
Act to furnish information about the transfer of securities in the names of the beneficial
owners to the company at regular intervals. Moreover, section 10 of the Depositories Act
requires maintenance of a register and an index of the beneficial owners, a copy of which
is supplied to the company at the time of dividend payment, rights or bonus issue, etc.

A public company cannot now refuse to register transfer of shares in view of the
aforesaid changes in the law. Any existing provision in the articles of a public company
empowering its Board to refuse registration of transfer of shares on any grounds,
whatsoever, shall be void.
However, the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 1997
which prescribe the manner in which a person can acquire more than 5% shares of a
listed company (by filing disclosures to the company) or more than 15% shares of a
company (by making a public announcement of his intention) continue to be valid. Thus,
while a company does not now have a right to refuse registration of transfer of shares, a
substantial acquirer of shares will have to follow the procedure as mentioned in the said
Regulations, which is mainly aimed at ensuring greater transparency in the substantial
acquisition of shares and the takeovers of companies.

Thus the only restriction on transfer of shares in a Public Limited Company is the
contract for transfer of shares must not be a “Forward Contract” and compliances under
the Takeover Code must be carried out.

Further in Mysore Fruit Products Ltd. and Others v. The Custodian and Others it was
held that since the shares of Unlisted Companies are “marketable” in nature therefore
SCRA will be applicable to unlisted public companies. Thus all the consequences
applicable to Listed Public Limited Company will follow in respect of an Unlisted Public
Company.

In Rajendra Rathore v. M.P. Stock Exchange, it was noted that:


The stocks and shares in the Exchange are dealt in three ways: (i) Forward Contracts(ii)
Ready delivery contract and (iii)Spot Delivery Contracts.
Forward contracts are contracts under which the parties agree for their performance at a
future date. These contracts sometimes also carry the risk of degenerating into
speculative transactions amounting to pure gambling which could subvert the main object
of Stock Exchange. That is why the Securities Contract (Regulation) Act, 1956 was
enacted to prevent undesirable transactions in securities by prohibiting certain business
action and by providing for some other connected matters.
A “spot delivery contract” means a contract which provides for, (a) actual delivery of
securities and the payment of a price therefore either on the same day as the date of the
contract or on the next day, the actual period taken for the despatch of the securities or
the remittance of money therefore through the post being excluded from the computation
of the period aforesaid if the parties to the contract do not reside in the same town or
locality;

(b) transfer of the securities by the depository from the account of a beneficial owner to
the account of another beneficial owner when such securities are dealt with by a
depository;

Admittedly a notification dated 27th June, 1969 has been published by the Central
Govt. which reads as follows :
S.O. 2561. In exercise of the powers conferred by Sub-section (1) of Section 16 of the
Securities Contracts (Regulation) Act 1956 (42 of 1956) the Central Government, being
of opinion that it is necessary to prevent undesirable speculation in securities in the whole
of India, hereby declares that no person, in the territory to which the said Act extends,
shall, save with the permission of the Central Government, enter into any contract for the
sale or purchase of securities other than such spot delivery contract or contracts for cash
or hand delivery or special delivery in any securities as is permissible under the said Act,
and the rules, bye-laws and regulations of a recognised stock exchange:

Provided that a contract other than a spot delivery contract or contracts for cash or hand
delivery or special delivery in any securities on the Cleared Securities List of a
recognised stock exchange may be entered into between its members or through or with
any such member for the purpose of closing out or liquidating all existing contracts
entered into, upto the date of this notification and remaining to be performed after the
said date, but such contracts shall be subject to the rules, bye-laws and regulations of the
recognised stock exchange that come into force when further new dealings are prohibited
in any securities on the Cleared Securities List and subject also to such terms and
conditions, if any, as the Central Government may from time to time impose.

1.3 Conclusion
Thus according to the abovementioned notification if a contract for sale of shares is
effected on a “spot delivery basis” then such contract will be valid and enforceable. Since
sale of shares by one shareholder to another shareholder through a depository amounts to
a “spot delivery contract”, if an arrangement is made where the sale of the shares in the
event of exercise of a put option by the investor is routed in a demat form through a
depository the exercise put option would not be violative of SCRA.

Opting for this kind of arrangement will rule out the possibility of sale of shares by
exercising put option from being brought within the purview “forward contract” as even
though there may be an element of the price of the shares, as on the date of sale of shares
being predetermined by way of the valuation mechanism it would still be a spot delivery
contract. However this conclusion can only be derived if a strict interpretation of the
meaning of “spot delivery contract is taken”. However if a restrictive interpretation is
resorted to then a problem can arise where sale of shares by way of put option even
though it is routed a depository can be can be considered to be a “forward contract” if the
court comes to the conclusion that price of the shares has been fixed at a date earlier than
the date on which the shares are to be actually delivered.

Thus the issue that a contract for sale of shares where a valuation mechanism is such that
in effect the price of the shares, which are to be sold on the date of exercise of put option,
is fixed even though such amount has not been expressed in the form of figures will
amount to a forward contract or not is still an open issue.

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