SEBI's latest move may give a fillip to SME fundings
SEBI's recent notification will hopefully reassure investors and open the door to more funding for SMEs
November 18, 2013 / 16:53 IST
Harini Subramani
Here's good news from the legal world for promoters and private equity investors. Last month, the Securities and Exchange Board of India (SEBI) notified that company contracts can now include clauses including a Call and Put option, and pre-emption rights. First, let's simplify these terms. An option is a right and not an obligation. A 'call option' is simply an option that allows existing shareholders to purchase shares at a fixed price within a specified time period. A 'put option' is an option to sell shares at a specified price before a specified period. A 'pre-emption right' is a right given to shareholders to be offered shares before they are offered to anyone else, including the right of first refusal. Note that this relates only to transfer of shares and not when shares are issued.Options are typically used by investors and promoters in a company and included in contracts (a share purchase or a share subscription agreement) as a means to safeguard interests and create exit and investment options at the right time.For example, if we take the Vodafone case when Mr. Ajay Piramal invested, there was an assurance of an 18% on the sum invested by latter. The idea behind this could be in the form of a put option which gives Mr. Piramal an assured return. These options have been under regulatory scrutiny for the simple reason that they act as quasi debt instruments in the garb of equity. Some promoters sell stake temporarily depending on the need of funds for the company. For investors, it gives an assurance for a later point in time for their investment depending on how the company is faring. A put option gives the investor the right to sell his shares if the company is not doing well and a call option will give him the right to buy more shares of the company if it is doing well. Moreover options have an impact on the cost of capital thereby having the potential of making it cheaper.SEBI's Earlier BanBefore analysing SEBI's latest move, let us understand the background. In 2000, SEBI had barred call and put options, pre-emption rights including the right of first refusal in company contracts and the Articles of Association (AoA) unless the contract had been in place for a minimum of a year.An AoA is a document that details the purpose of the company and establishes the means to achieve its stated goals. This ban was applicable to both listed and unlisted public companies but however did not include private companies.The extension to unlisted public companies was made via various court judgments. More recently, in 2010, in the case of Naresh Aggarwala and Co vs Canbank Financial Services, the Supreme Court observed that the definition of 'securities' in the SCRA did not distinguish between listed and unlisted securities and, therefore, the ban was applicable to even securities that were not listed on any recognised stock exchange in India. This essentially meant that an investor had very limited options with regard to his decision to exiting a company. Such a contractual obligation and lack of choice made potential investors very cautious.Moreover, Call and Put options were not technically classified as legal contract clauses as they were excluded from the ambit of the Securities Contracts Regulation Act. (SCRA). Why The Notification Is BeneficialSEBI's notification of October 3, 2013, brings relief to companies and investors. An SME most often is either private or a public unlisted company. For a private company, there is no legal ban on the inclusion of the call and out options. Thus for an early stage investor, in the case of a short term investment horizon, funding is easier. But most companies eventually aim to go public. The logic usually is that private debt involves high capital costs and so, the sooner an investor exits, the better. Thus as part of a company's evolution, it is necessary to even change its capital structure and move from being a private entity to a public entity in order to eventually list itself.The presence of such options protects interests of investors and promoters. Unresolved IssuesThe recent notification has sparked an interesting debate that centres on an apparent contradiction relating to Section 194 of the new Companies Act 2013. The contradiction relating to Section 58(2) seems to have been automatically answered.
Section 154 explicitly prohibits forward dealings in securities by a director or by key managerial personnel. This essentially puts a spanner in the works for a company internally. Thus, the MCA would need to clarify, especially considering criminal liability is attached if this section is contravened. Section 58(2) pertains to the free transferability of securities in a public, unlisted company. This essentially is a distinguishing factor between a private and public limited company. Without this notification, pre-emption rights would have been violative and the Ministry of Corporate Affairs (MCA) would have had to clarify on whether the AoA need to include such a right. Although, high courts have maintained that a pre-emptive right is essentially ultra-vires.
In addition, the latest notification states that this will be applicable to contracts entered into only after the date of this notification. It does not apply to existing contracts. While more clarity is needed the Reserve Bank of India on investments where foreign exchange is concerned, an option for companies otherwise would be to re-execute existing contracts to include the current provisions. You can send your feedback on smementor@moneycontrol.com or simply post comments below Discover the latest Business News, Sensex, and Nifty updates. Obtain Personal Finance insights, tax queries, and expert opinions on Moneycontrol or download the Moneycontrol App to stay updated!
