OPTIONS AND PREEMPTIVE RIGHTS Flashcards
(13 cards)
Right of First Offer (ROFO)
The Right of First Offer (ROFO) grants the ROFO holders the opportunity to purchase shares before the selling shareholder can offer them to external parties. The selling shareholder must first offer the shares to the ROFO holder who will make an ‘offer’ specifying the price at which they intend to acquire the shares.
If the such offer is not acceptable to the selling shareholder, then, the selling shareholder is free to sell the shares to third parties, at a price not less than offered by ROFO holder and on similar terms. Price discovery for the shares is undertaken by the ROFO holder in this case. Both for ROFO and ROFR (below), overall transfer restrictions to competitors typically continue to apply.
Right of First Refusal (ROFR)
The Right of First Refusal (ROFR) grants the ROFR holder priority to purchase the sale shares before the selling shareholder can sell them to an external third-party by matching/ out-bidding the offer received by the selling shareholder from the third-party.
In this process, the third-party undertakes the diligence for price discovery of the shares and makes an offer to the selling shareholder, who in turn notifies the ROFR holder of the offer.
A ROFR obligation is considered to be more onerous than a ROFO as it is seen to dissuade a third-party from undertaking price discovery and making an offer in the first instance as the sale may be easily blocked by a ROFR holder by offering a marginally better price than that offered by the third party.
What is a Term Sheet?
A term sheet is essentially a non-binding agreement that outlines the basic terms and conditions under which an investment will be made. It serves as a blueprint for later drafting more detailed, legally binding agreements. The term sheet sets the stage for negotiations, guiding lawyers in creating definitive agreements to formalize the transaction.
NTT Docomo Inc v Tata Sons Limited
The concept of ‘assured returns’ refers to a scenario where an investee company provides a guarantee of a fixed rate of return to an investor on its investment at the time of exit. Assured returns on equity investments by foreign investors are generally prohibited. The rationale is that equity, by nature, is a risk-bearing instrument, and guaranteeing a minimum return or exit price to a foreign investor is seen as contrary to the spirit of FDI policy.
Instead, any exit by a foreign investor must be at the fair market value determined at the time of exit, as certified by a chartered accountant or other approved professional. Pre-arranged exit prices or guaranteed returns are not allowed, as they would amount to an “assured return,” which is not permitted under FEMA and RBI’s Pricing Guidelines.
In 2009, NTT Docomo (a Japanese company) invested money in Tata Teleservices (an Indian telecom company).
Their agreement said that if Tata Teleservices didn’t meet certain business goals, Docomo could sell its shares and get back at least half of what it originally invested.
By 2014, Tata Teleservices had not met those goals, so Docomo wanted to exit and get its money back. The agreement required Tata to help Docomo find a buyer who would pay this pre-agreed price (half the original investment).
Tata couldn’t find any buyer willing to pay that much. So, as per their agreement, Tata offered to buy back Docomo’s shares themselves for about $1.17 billion.
The Reserve Bank of India (RBI) objected, saying Indian law does not allow foreign investors to be guaranteed a fixed return or a set price when they sell shares. The law says foreign investors can only sell shares at the market value at the time, not at a pre-decided amount. The RBI said this deal looked like an “assured return,” which is not allowed.
Docomo took Tata to arbitration in London. The arbitrators decided Tata had broken their contract and ordered Tata to pay Docomo the $1.17 billion as compensation.
Tata and Docomo went to the Delhi High Court to enforce this decision. The court said the payment was not an “assured return” on investment (which is illegal), but rather damages for not fulfilling the contract (which is allowed). The court also ruled that the RBI could not stop the payment between Tata and Docomo, since it was about enforcing a contract, not guaranteeing investment returns.
Call Option
A ‘Call Option’ gives a shareholder the right, but not the obligation, to compel another shareholder to sell their shares to the call option holder at a predetermined price within a certain timeframe and/or upon occurrence of specific events.
Put Option
A ‘Put Option’ gives a shareholder the right, but not the obligation, to compel another shareholder to purchase the shares of the put option holder at a specified price within a certain timeframe and/or upon occurrence of specific events.
Percept Finserve Pvt. Ltd. v. Edelweiss Financial Services Ltd
Background:
In December 2007, Edelweiss purchased shares of Percept Limited from Percept Finserve for INR 20 crores, with an SPA that included a put option: if Percept failed to meet certain conditions, Edelweiss could require Percept Finserve to repurchase the shares at the original price plus a 10% internal rate of return.
Percept did not fulfill the conditions, Edelweiss exercised the put option, but Percept did not comply, leading Edelweiss to initiate arbitration.
The arbitral tribunal ruled the put option was a forward/derivative contract and thus illegal under SCRA notifications, but this award was set aside by a single judge of the Bombay HC, prompting Percept to appeal.
Legal Issues:
The core question was whether the put option clause was valid under the SCRA and related SEBI notifications, especially since the SPA and exercise of the option predated the 2013 SEBI notification that expressly permitted such clauses.
The 2000 SEBI notification prohibited contracts for sale/purchase of securities except spot delivery or permitted derivatives, and the 2013 notification clarified the legality of shareholder agreement options but did not retroactively validate earlier contracts.
Key Findings of the Bombay High Court:
Put option is not a forward contract: The Court held that a put option does not create a present obligation but only a contingent one, arising only if certain events occur and the option is exercised. Thus, it is not a forward contract prohibited by the SCRA.
Put option is not a contract in derivatives: The put option was not considered a derivative contract under Section 18A of the SCRA. The law prohibits trading in such options as securities, not the existence of the option itself within a private agreement.
Spot delivery contract: Upon exercise, the repurchase obligation was to be fulfilled immediately or within the statutory period, qualifying as a spot delivery contract, which is permitted under the SCRA.
Retrospective validity: The Court clarified that put option clauses were never prohibited even before the 2013 SEBI notification. The 2013 notification only clarified the position and did not affect the legality of pre-existing put options.
Impact:
This judgment upholds the enforceability of put option clauses in SPAs, provided they are not traded as securities and fulfill spot delivery requirements.
It provides clarity and legal certainty for private equity and investment transactions in India, confirming that such contractual rights are valid and enforceable under Indian securities law.
Forward Contracts
Forward contracts are firm arrangements for purchase and sale of securities at a future date at a predetermined price. In such contracts, the seller is bound to sell and the purchaser is bound to purchase, with the only condition being the lapse of time.
Neither party is entitled to make any decision whether to perform the contract (or not), and hence a “contract for the purchase and sale of securities” can be said to have come into existence at the time of execution of the contract itself.
On the other hand, an option is a different type of contract. An option only provides an entitlement to purchase or sell securities.
An option holder may either exercise the option, or allow it to lapse, depending on the circumstances. A firm contract for purchase and sale, which creates a legally binding purchase and sale obligation, arises only when the option is exercised in accordance with the terms of the contract.
The obligation to purchase and sell comes into existence upon the occurrence of a contingency, which is the exercise of the option; an option can at best be a contingent contract.
History of Call and Put Options
The enforceability of put option clauses in India has evolved significantly:
Initially, Section 20 of the Securities Contracts (Regulation) Act, 1956 (SCRA) made all options in securities illegal, reinforced by a 1969 Ministry of Finance notification prohibiting contracts other than spot/cash/special delivery contracts.
In 1995, Section 20 was repealed, but the 1969 notification remained, keeping the prohibition effectively in place.
In 2000, SEBI replaced the 1969 notification with a similar one, continuing to prohibit such option contracts except for spot delivery and certain derivatives traded on recognized exchanges.
Section 18A, introduced in 1999, clarified that only derivatives traded on recognized exchanges or as notified by the government are legal, but did not specifically address shareholder agreement options.
SEBI’s 2013 Notification was a turning point: it rescinded the 2000 notification and, for the first time, expressly permitted put and call options in shareholder agreements or articles of association, provided:
* The seller holds the securities for at least one year,
* The price complies with applicable law,
* Settlement is by actual delivery,
* The contract complies with FEMA
Liquidation Preference - A Downside Protection
‘Liquidation Preference’ is a right to receive a preferred payout in the event of liquidation of the investee entity or divestment of its assets, in priority to the remaining equity shareholders of the company. This payment is made after the payments to the creditors of the Company, who are statutorily required to be provided precedence in any such distribution of liquidation proceeds. A liquidation event typically includes, not just only winding up of the company or insolvency, but also the change of control events of the investee entity or group that is caused by merger, demerger and share sale or significant sale of assets of the investee entity or group.
Share Subscription Agreement (SSA)
An SSA is a legal contract between an investor and a company, whereby the investor agrees to subscribe for newly issued shares in the company.
This agreement outlines the terms and conditions under which the investor acquires the shares, including the number of shares, the price per share, and any representations or warranties made by the parties.
The issuance of new shares typically results in an increase in the company’s share capital and may dilute the ownership stake of existing shareholders.
Share Purchase Agreement
An SPA is a legal contract between a buyer and a seller, where the buyer agrees to purchase existing shares in a company from the seller.
The SPA sets forth the terms and conditions of the sale, including the number of shares being sold, the purchase price, and any representations, warranties, and indemnities provided by the parties.
Unlike an SSA, an SPA does not affect the company’s share capital or result in dilution of existing shareholders, as the ownership stake is transferred from the seller to the buyer.
Varun Tyagi v. Daffodil Software Private Limited
The judgment found that non-compete restrictions post termination of a contract violate Section 27 of the Indian Contract Act, which prohibits agreements that restrain lawful professions or trades.
