Published On: December 30, 2021 at 11:30 IST
Introduction
The Securities Contract Regulation Act, 1956 went into effect more than 60 years ago, but the dust regarding spot delivery contracts hasn’t settled until now.
The current definition of a “spot delivery contract” includes actual delivery of securities and payment of the contract amount within one day of the contract date. The date of contract is usually the day on which the parties agree to enter into a contract. This creates a problem because the actual delivery of shares and payment are rarely completed on the date of the contract or within one day of it.
The question of whether spot delivery contracts are the only exception to stock exchange trading mechanisms and if “put” and “call” options in a shareholders agreement violate SEBI Rules and Regulations has been debated for some time.
This research gives an overview of what’s going on in our country on the subject and how it’s affecting the sector as a whole. It will include the laws relating to spot delivery contracts and what is the approach Judiciary has opted to deal with issues related to Spot Delivery Contracts.
Legality of Spot Delivery Contracts
The Securities Appellate Tribunal recently discussed the interplay between Section 13 and Section 2(i) of the Securities Contract (Regulation) Act in the case of Bhanuben Jaisukhlal Shah Vs Securities and Exchange Board of India[i], and stated: “Since all securities prior to the coming into force of the Depositories Act were held in the physical form, spot delivery contract was defiant.”
In other terms, a spot delivery contract is an agreement between two people who buy and sell assets off-market, with delivery and payment taking place the same day or the following day. As previously stated, such contracts are acceptable since they are free from the Act’s Section 13 restrictions. The foregoing observation clearly reveals that contract on spot delivery basis is the lone exception, and that there is no alternative means to trade shares of a publicly traded firm other than on the Stock Exchange except on spot delivery basis.
Spot Delivery Contracts under the Securities Contract (Regulation) Act, 1956
The term “spot delivery contract” is defined as follows in Section 2(i) of the Securities Contracts (Regulation) Act, 1956 (hereinafter as SCRA):
“(i)”spot delivery contract” means a contract which provides for,— (a) actual delivery of securities and the payment of a price therefor either on the same day as the date of the contract or on the next day, the actual period taken for the dispatch of the securities or the remittance of money therefor 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; Section 2(i)(a) was a part of the original enactment.”[ii]
However, after introduction of Depositories Act, 1996, Section 2(i)(b)was inserted so as to cover transactions done through depository mechanism as well.
The provisions of Section 13 of the SCRA must also be included here. This Section makes it illegal to conduct a securities transaction in a notified region that is not between or through members of a recognized stock exchange. That in order for a transaction in securities to be lawful, it must be conducted between members of a recognized stock exchange, through a member of a recognized stock exchange, or with a member of a recognized stock exchange.
The SCRA’s Section 18 exempts spot delivery contracts from Section 13’s application. When Sections 13 and 18 of the SCRA are read along with Section 2(i) of the SCRA, it is clear that trading outside the stock exchange mechanism is prohibited. With the special needs of people in mind, a very specific exception of spot contract has been carved out. To take use of this exception, however, rigorous adherence to the restrictions outlined in the Section is essential.
In common language, it is obvious that if a securities transaction is completed through the depository system, it must comply with the provisions of Section 2(i)(b) – for the transfer of securities – and Section 2(i)(a) – for the payment of securities. To put it another way, the provisions of Sections 2(i)(a) and 2(i)(b) must be read together, not separately, in order to reach a meaningful conclusion.
In June 1969, the Central Government issued a notification under Section 16 of the Securities and Exchange Commission Act (1969 Notification) prohibiting all contracts for the sale or purchase of securities other than spot delivery contracts, cash or hand delivery contracts, or special delivery contracts. On March 1, 2000, the 1969 Notification was revoked, and the ability to regulate securities contracts was divided between SEBI and the Reserve Bank of India. SEBI issued directions under Section 16 of SCRA by Notification No. SO 184(E) dated 1 March 2000, which had the same effect as the 1969 Notification. The following is from the Notification of 2001:
“……………………………… the Securities and Exchange Board of India being of the opinion that it is necessary to prevent undesirable speculation in securities in the whole of India, hereby declare that no person in the territory to which the said Act extends, shall, save with the permission of the Board, enter into any contract for sale or purchase of securities other than such spot delivery contract or contract for cash or hand delivery or special delivery or contract in derivatives as is permissible under the said Act or the Securities and Exchange Board of India, Act, 1992 and the Rules and Regulations made under such Acts and Rules, Regulations and Bye-laws of a recognized Stock Exchange”.
The Judicial Analysis of SCRA and Spot Delivery Contracts
- Jethalal C. Thakkar Vs R.N. Kapur[iii]
In this case, the Bombay High Court Division Bench distinguished between a contract in which there is a present obligation and performance is postponed to a later date, and a contract in which there is no present obligation at all, and the obligation arises as a result of some condition being met or a contingency occurring. The Court concluded that a contract that was contingent in character at the time it was made was no contract at all, and that the contract only comes into existence when the contingency occurs, and the time period specified in the contract expires. A contract like this was found to be lawful and enforceable.
- Niskalp Investments and Trading Co. Ltd Vs Hinduja TMT Ltd.[iv]
In this case, the Bombay High Court disagreed with the decision in Jethalal’s case (above), holding that a put option was unenforceable since it was not a spot delivery contract. The court found that the deal was a contract for future performance and not a spot delivery contract in the said case, where the investor had the option of selling his shares at a predetermined price or opting for an initial public offering to depart.
- MCX Stock Exchange Limited Vs SEBI[v]
In this case, the Bombay High Court addressed, among other things, whether buy back agreements were forward contracts that violated the SCRA’s regulations. The Whole Time Member of SEBI ruled that the buyback agreements are forward contracts and not authorized arrangements under the SCRA, according to the judgement.
Based on the facts of the case, the Court determined that under a buy-back agreement of the type engaged in this case, the promissor who makes a buy-back offer cannot compel the promisee to exercise the option to sell the shares at a later date.
The promissor cannot force performance if the promisee declines to exercise the option. Only when the promisee to whom an option is granted exercises the option to sell the shares does a completed contract for the sale and purchase of shares come into existence. As a result, having the option to purchase or repurchase is considered a privilege. A sale and purchase agreement simpliciter, on the other hand, is a reciprocal agreement that imposes obligations and advantages on both parties and is enforceable at either party’s request.
The Court determined that the contract for the sale or purchase of the securities would only be fulfilled if PNB or, as the case may be, IL&FS exercised the option in the future. There would be no contract for the sale or purchase of securities if they did not exercise their option. The Court based its ruling on a previous judgement of the Bombay High Court in the case of Jethalal. Although a subsequent ruling by a single judge in Niskalp Investments’ case (above) to the contrary was made, it was not examined because it was issued on a summons for judgement in a summary suit and did not advance the discussion.
Following the Bombay High Court’s decision, the SEBI filed an SLP with the Supreme Court under Article 136 of the Indian Constitution. On April 11, 2012, the Supreme Court dismissed the SLP under the provisions of a consent order. The Supreme Court, on the other hand, has made no negative comments about the High Court’s findings.
- Edelweiss Financial Services Ltd. Vs Percept Finserve Pvt Ltd. and Anr.[vi]
In this recent case, the Bombay High Court (“Court”) upheld the validity of a put option clause that dated back before 2013, ruling that it is neither a forward contract nor a “contract in derivative” that is prohibited from being traded under the SCRA.
FACTS
Percept Finserve Private Limited (“Promoter”) and Edelweiss Financial Services Limited (“Edelweiss”) entered into a Share Purchase Agreement (“SPA”) dated December 8, 2007, for the purchase of certain shares of Percept Limited (“Percept”). The SPA stated that if Promoter/ Percept violated certain conditions, Edelweiss would have the option to:
- Sell the shares back to the Promoter at a price that would give Edelweiss an internal rate of return (IRR) of 10% (“Put Option”), or
- Continue to hold Percept shares subject to certain undertakings from Promoter.
The Promoter and Percept, according to Edelweiss, failed to meet certain SPA responsibilities. As a result, it exercised its Put Option and requested that the Promoter buy its shares. The Promoter, on the other hand, refused to accept the Put Option. As a result, arbitration was initiated, and a single arbitrator was selected to resolve the disagreements. The arbitrator found that the Promoter and Percept had broken their SPA responsibilities, but he dismissed Edelweiss’ Put Option claim as invalid.
AWARD
The arbitrator found that the Put Option was illegal on two counts:
- It was a forward contract, which is prohibited under Section 16 of the SCRA and SEBI circular dated March 1, 2000; and
- It was a derivatives contract that was not traded on a recognized stock exchange, as required by Section 18-A of the SCRA.
ARGUMENTS BY EDELWEISS
The award, Edelweiss contended, is in direct conflict with the Bombay High Court’s decision in MCX Stock Exchange Ltd Vs SEBI[vii] (“MCX Judgment”). The MCX Judgment stated that put option contracts are not forward contracts[viii] since they are constituted on the date the option is exercised and can thereafter be performed as spot delivery contracts.[ix] Second, Edelweiss contended that the Put Option is not a derivative in the sense of Section 18A of the SCRA.
ARGUMENTS BY PERCEPT
The current case, according to the promoter, is distinct from the MCX Judgment. Edelweiss exercised its Put Option in this case, requiring the Promoter to purchase the shares within a certain time frame rather than immediately. Even after the Put Option was exercised, the purchase of shares was postponed. As a result, it constituted a forbidden forward contract. The Promoter further claimed that the Put Option, being a future buyback option, was a derivative that was banned if not handled properly under Section 18A of the SCRA.
It was further claimed that a SEBI circular dated October 3, 2013[x] (“SEBI 2013 Circular”) protected option contracts included in a shareholder’s agreement. The SEBI 2013 Circular specifically stated that no contract is valid before its expiration date. As a result, prior to 2013, entering into such option contracts was almost likely illegal.
JUDGEMENT
The Court decided that the current case was covered by the MCX Judgment, which stated that a put option cannot be construed as a forward contract. It is carried out on a spot delivery basis, which means that both the delivery of shares and the payment of the price occur simultaneously or within one day of the contract’s inception. The contract comes into existence, if at all, when two circumstances are met:
- Promoter’s failure to restructure within the specified time frame, and
- Edelweiss’ exercise of its option to force buyback by Promoter in the event of such failure.
It further held that the Put Option could not be considered a forward contract simply because the Promoter was given time to repurchase after the Put Option was exercised. There was no indication that there would be any delay between payment and delivery of shares, or that shares would be supplied first, and the amount paid later, or vice versa.
The Court next considered the Put Option in light of Section 18A of the SCRA. Section 18A stated that “derivative contracts” are legal and valid if they are:
- Traded on a recognized stock exchange,
- Settled on a recognized stock exchange’s clearing house, or
- Between such parties and on such terms as the central government may specify in accordance with the stock exchange’s rules and byelaws.
The Court determined that Section 18-A did not ban the purchase of a call or put option in and of itself, but only controlled the trading or dealing in such options as a security.
The Court clarified that the SEBI 2013 Circular was not a saving notification, but rather a prohibitory one, as it barred all contracts except those listed therein. Second, the Court determined that if a deal was only an options contract, it could not be saved by the SEBI 2013 Circular because such contracts were never outlawed in the first place.
The arbitrator erred on these fundamental points, according to the Court, because he classified the deal as a “contract in derivative” simply because it included a put option on stocks. As a result, the arbitral award was set aside by the Court due to its illegality.
Can a Spot Delivery Contract be considered an Options Contract?
SCRA gives the government the authority to prohibit certain types of securities sales or purchases in order to “avoid unwanted speculation in the specified securities.”[xi]
The same power was assigned to SEBI[xii], in response to which SEBI published Notification No. 184(E) stating that no one shall enter into “contracts for sale or purchase of securities” other than “spot delivery contracts or contracts for cash, hand delivery, or special delivery.”[xiii]
“Spot delivery” indicates that the actual transfer of the security and payment for it must take place within two days of the agreement being signed.
According to SEBI’s line of reasoning in its judgements and informal guidance, if the interval between the date of grant of an option and the date of exercise is more than two days, the “spot delivery” criteria is violated. It is maintained that an option constitutes a legally binding “contract for the sale or purchase of securities” even before the option-holder exercises the option; only the option writer’s responsibility to impart is subject to the contract’s exercise. When one party exercises an option, the other acquires an instant unilateral obligation, the discharge of which is contingent on the holder’s option-will. [xiv]
The parties have entered into a legally binding contract as a result of this arrangement.[xv] An option contract is one in which a binding contract exists at the moment of agreement, but the contract’s fulfilment, i.e. the delivery of the underlying shares, has been postponed to a later date.[xvi] As a result, an option agreement was deemed to be in violation of the notification since it constituted a formal contract for the sale/purchase of securities with a settlement time of more than two days.
The matter at hand, however, is far more complex than it appears, and it deserved further attention, which it received in the Bombay High Court’s decision in MCX Stock Exchange Ltd. Vs SEBI.[xvii]
The Court stated that the notification prevented an agreement for the purchase or sale of securities where there is an obligation in present whose fulfilment has been deferred to a future date, citing an older decision on the issue. A contract in which the obligation arises as a result of a future dependent event is not in violation of the notice requirement.[xviii] It was decided that an option is not a definite contract for the acquisition or sale of shares until it is exercised, and that the question of breaking the notice would only arise after the option was exercised.
The Court’s ruling clarified that under Section 2(d) of the SCRA, a “option in securities” is defined as “a contract for the sale or acquisition of a right to buy or sell securities in the future.”[xix] It gives the holder the option, but not the duty, to buy or sell underlying securities at a predetermined price at a future period. It is not in the nature of a completed contract for the sale or purchase of shares to impose reciprocal responsibilities on the parties, whereby one party can compel the other to fulfil his or her part of the agreement.[xx] It’s a rare opportunity.[xxi] The Court reaffirmed the distinction between an option and a purchase or sale agreement, which was first defined by the Supreme Court in VS Pechimuthu Vs Gowrammal[xxii] as:
“12. … an option by its very nature is dependent entirely on the [unilateral] volition of the person granted the option. He may or may not exercise it. Its exercise cannot be compelled by the person granting the option.…
13. ….An agreement for sale and purchase simpliciter … is a reciprocal arrangement imposing obligations and benefits on both parties and enforceable at the instance of either.”
As a result, it was decided that an option does not become a “contract for the sale or purchase of securities” until it is exercised. It’s merely a “option” before that. As a result, the underlying securities must be delivered, and the price paid within two days of the option being exercised. If both conditions are met, the arrangement is still considered a “spot delivery” contract. This division of an option agreement into two contracts is supported by English jurisprudence, which describes an option as an offer[xxiii] that becomes a “contract for the sale or purchase of shares” only when the option is exercised.
An option agreement is a “firm offer,” that is, an offer that includes a pledge not to retract it for a set period of time. It consists of two offers to engage into two contracts, the first of which is a “main” contract for the sale or purchase of the shares, and the second of which is a self-executing offer to keep this offer open for a specified duration.[xxiv] In relation to the “major” offer, the “minor” contract is stated to produce an irrevocable offer and a power of acceptance in the holder. As a result, “the option grantor has a conditional duty, and the option-holder has a conditional right of performance of the option offer, the condition being the exercise of the power of acceptance by the option-holder.”
However, the author believes that dividing an agreement into two separate contracts is unworkable. A general rule is that any transaction must be viewed as a whole and not split into its essential elements.[xxv] Though viewing the agreement as two independent contracts is a wonderful idea in theory, there are no two separate contracts in fact. There is only one choice agreement that establishes the parties’ rights and responsibilities. Furthermore, the most important aspect of any share purchase transaction, the price at which the shares are to be purchased, which in this case is the “strike price,” is determined by the principal option agreement and not by any other contract.
In the absence of such, the shares would have to be bought or sold at the current market rate or valuation. As a result, an option contract cannot be divided into two halves and is consequently a “transaction for the purchase or sale of securities.”
To be fair to the Bombay High Court, while the logic in MCX was incorrect, the result was unquestionably positive. One may even say that the decision in MCX was based on the outcome.
The Court recognized that legalizing put, and call options was critical to attracting foreign investment and revitalizing a faltering economy, and that an appropriate legislative response would inevitably be hampered by delays.
In contrast to SEBI’s technique of mechanically reading the notice, the researcher believes that referring to the object of passing the notification[xxvi] would have been a better way to achieve the same objective. The underlying goal of SEBI’s notification was to “avoid undesired securities speculation in India as a whole.”[xxvii]
The term “speculation” refers to engaging in risky commercial operations or investing in dangerous assets or commodities in the hopes of making a large profit.[xxviii] A “speculative transaction” is one in which “a contract for the purchase or sale of any commodity is periodically or eventually resolved by means other than physical delivery or transfer” of the commodity or scrip.[xxix] There is a significant distinction between options issued as part of investment agreements and those sold for speculative purposes.
The former is a cash-settled transaction or a contract for differences in which the investor aims to take a genuine stake in the shares of the investee company. SEBI’s newest announcement (described below) attempts to address this by establishing parameters that identify real options agreements from speculative ones, something that should have been done a long time ago.
Conclusion & Suggestions
The recent stance taken by SEBI, the capital market’s primary regulatory agency, on the enforceability of put options in the Cairn – Vedanta deal, or the informal counsel issued to Vulcan Engineers Limited, or in the instance of the MCX, has reignited the argument. It is expected to have an impact on a variety of investment transactions in both listed and unlisted companies where put and call options are commonly used. The Courts’ ruling, which differed with SEBI’s, has added to the complexity of the situation while also keeping private equity investors’ aspirations alive. The scope and extent of enforceability of spot delivery contracts thus remain vague unless the issue is resolved by the higher judiciary or by some express notification.
Despite the fact that SCRA has been in effect for almost 60 years, the debate over spot delivery contracts continues to this day. The current decision is admirable because it gives optimism that these concerns are now getting the attention they need, even if it is a little late.
SEBI issued a circular on March 1, 2000, 6 prohibiting all contracts save spot delivery contracts and derivatives contracts. Following that, SEBI issued an informal guideline 7 in 2011, noting that a call or put option is not legitimate because it is not a spot delivery contract.
Following the MCX Judgment, SEBI expanded the scope of permitted contracts under the SCRA in 2013, including option contracts (such as put/call) contained in a shareholder’s agreement, which were declared permissible and valid by SEBI 2013 Circular.
The current definition of a “spot delivery contract” includes actual delivery of securities and payment of the contract amount within one day of the contract date. The date of contract is usually the day on which the parties agree to enter into a contract. This creates a problem because the actual delivery of shares and payment are rarely completed on the date of the contract or within one day of it. However, the Court has now stated that a spot delivery contract would exist if the delivery of shares and payment of the price occurred concurrently. This appears to be the provision’s genuine intent.
The Court concluded that Section 18-A of the SCRA does not, on its own, render any contract illegal. It only validates contracts that include the features listed in clauses (a) through (c). To declare a contract illegal or invalid, one must examine beyond Section 18-A. This Court interpretation is a step in the right direction because it clarifies that the clause means exactly what it states. Furthermore, the Court has defined the fundamental meaning of Section 18-A, namely, that it only applies to trading or dealing in options as a security, not to entering into options contracts per se. This Court’s interpretation also supports our 2012 examination of this problem, which may be seen here.
Surprisingly, courts have previously decided that SCRA only applies to shares of public firms because they are easily transferable.[xxx] However, based on the new Companies Act of 2013, it is now possible to argue that SCRA also applies to private company securities. This is because the Companies Act of 2013 definition of “securities” has been linked to the SCRA definition of “securities.” 10 As a result, “securities” issued under Companies Act of 2013 are arguably nothing more than “securities” under SCRA, to which the SCRA’s requirements may apply. Furthermore, in some situations, the shareholders agreement specifies that investors’ shares are readily transferrable. The provisions of the SCRA may also apply in certain situations. However, how the courts will apply SCRA in light of the new Companies Act of 2013 remains to be seen.
[i] Bhanuben Jaisukhlal Shah Vs Securities and Exchange Board of India, 2010 SCC OnLine SAT 92
[ii] Section 2(i) of the Securities Contracts (Regulation) Act, 1956 (“SCRA”)
[iii] Jethalal C. Thakkar Vs R.N. Kapur AIR 1986 Bom 74
[iv] Niskalp Investments and Trading Co. Ltd Vs Hinduja TMT Ltd. 2005 SCC OnLine Bom 1510
[v] MCX Stock Exchange Ltd. Vs SEBI (2012) 2 Bom LR 1002. (Hereinafter “MCX”).
[vi] Edelweiss Financial Services Ltd. Vs Percept Finserve Pvt. Ltd., 2019 SCC OnLine Bom 732
[vii] MCX Stock Exchange Ltd. Vs SEBI (2012) 2 Bom LR 1002.
[viii] Securities And Exchange Board of India vs. Rakhi Trading Pvt. Ltd, (2018) 13 SCC 753- Para 17.2- A future contract is an agreement between two parties to buy or sell an asset at a certain time in future at a price agreed upon on the date of the contract.
[ix] Section 2(i), Securities Contracts (Regulation) Act, 1956.
[x] Notification No. LAD-NRO/GN/2013-14/26/6667 dated October 3, 2013
[xi] Section 16, Securities Contract (Regulation) Act, 1956
[xii] Securities and Exchange Board of India, Notification No. SO 573(E) dated 30-7-1996
[xiii] Securities and Exchange Board of India, Notification No. SO 184(E) (1-3-2000).
[xiv] Arthur L. Corbin, Corbin on Contracts (Vol. 1, 27th Edn., Reprint 2001) 367
[xv] Pollock & Mulla, Indian Contract Act and Specific Relief, Vol. 1 (13th Edn., 2006) 936.
[xvi] Niskalp Investments and Trading Co. Ltd. Vs Hunduja TMT Ltd., (2008) 143 Comp Cas 204 (2007) 79 SCL 368 (Bom).
[xvii] MCX Stock Exchange Ltd. Vs SEBI (2012) 2 Bom LR 1002.
[xviii] Jethalal C. Thakkar Vs R.N. Kapur, AIR 1956 Bom 74.
[xix] Section 2(d), Securities Contract (Regulation) Act, 1956
[xx] MCX Stock Exchange Ltd. Vs SEBI (2012) 2 Bom LR 1002.
[xxi] Shanmugam Pillai Vs Annalakshmi Ammal, AIR 1950 FC 38; K. Simrathmull Vs Nanjalingiah Gowder, AIR 1963 SC 1182.
[xxii] VS Pechimuthu Vs Gowrammal (2001) 7 SCC 617.
[xxiii] Pritchard Vs Briggs, 1980 Ch 338: (1978) 2 WLR 317 : (1978) 1 All ER 886 (CA).
[xxiv] Halsbury’s Laws of England (4th Edn., 1974), 106, para 235
[xxv] Vodafone International Holdings BV Vs Union of India, (2012) 6 SCC 613
[xxvi] Carew and Co. Ltd. Vs Union of India, (1975) 2 SCC 791.
[xxvii] Securities and Exchange Board of India, Notification No. SO 184(E) (1-3-2000).
[xxviii] Black’s Law Dictionary, 1399 (6th Edn., 1990).
[xxix] Section 43(5), Income Tax Act, 1961
[xxx] Bhagwati Developers Pvt. Ltd. Vs Peerless General Finance & Investment Co. Ltd., 2013 SCC OnLine Cal 13482 or Dahiben Umedbhai Patel Vs Norman James Hamilton, 1982 SCC OnLine Bom 295