Shareholders Agreement

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.

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.

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.

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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