The Bombay High Court recently came out with a decisive ruling in favour of stock exchange MCX-SX and Sebi’s denial of a full licence to operate as an exchange. The ruling needs to be seen not just in the context of the competitive landscape of exchanges that has been improved in a single stroke, but should be welcomed by all investors and companies in India as it brings positive certainty for investment contracts. It puts to virtual rest a quixotic 40-year-old circular that has rarely been analysed in detail by a court of law.
Sebi had relied on four main grounds: (a) the regulations permitted a person (alone or acting in concert) to own only 5% voting rights in an exchange and the promoters held more than that, (b) the manner of reducing the voting rights to below 5% was not approved by regulations, (c) issue of warrants without voting rights to promoters would breach economic concentration of interest, and (d) there were buyback arrangements with companies (many public sector) of the exchange’s shares that were illegal forward contracts and were notdisclosed to the regulator.
The first two issues were decided in favour of the exchange, on an undertaking by the shareholders to be in compliance with the 5% cap at all times going forward, and Sebi acceded to the legal position that there was no relevant method prescribed for reducing the shareholding for new exchanges under the relevant regulations. The third issue of economic concentration of power by issue of voteless warrants was not based on any legal provision and the Sebi counsel, the additional solicitor general, rightly didn’t urge it because it was so specious. The law was to prevent concentration of voting power and control, not economic power as would result if and when warrants were to be converted into shares in the future. The provision is borrowed from Sebi’s takeover law that looks at control of votes and under which warrants do not trigger an open offer till converted into voting shares.
The question of persons acting in concert was tested on the principle laid down by the Supreme Court in the case of Daiichi Sankyo. It is now well settled that the mere fact that two persons have come together in promoting a company does not lead to the inference that they are acting in concert for the purposes of takeover regulations. Additionally, since the promoters had given an undertaking to reduce their stakes below 5%, the high court ruled in their favour, with a remark that ‘a genuine attempt has been made by the promoters by tendering an undertaking to the court’. Lastly, on the buyback arrangement, before the high court, Sebi did not support the ground that the buyback agreements constitute forward contracts. Hence, the high court distinguished the buyback agreements entered into by the promoters in the present case and held that buybacks are not illegal as these are not forward contracts, and consequently, the argument that MCX-SX is not a fit and proper person also ceases to exist.
The fourth issue is important for people who have no interest in the exchange space as it would impact commercial shareholder and other such agreements between people. Sebi’s stand in the matter previously was wrong (see my piece on Sebi’s mandate on Vedanta-Cairn deal, Shareholders’ Option Put Down, ET, April 22, 2011). The Bombay High Court case holds that options contracts do not fall within the ambit of the prohibition of a circular of 2000 as an option is a right without an obligation to purchase in the future. The right gets crystallised only on exercise of the option in the future. And when it does, it is a transaction that is completed on a spot basis, i.e., delivery is immediate. Therefore, there is no violation of the 2000 circular that prohibits trades except spot trades.
If you heard a collective sigh of relief of institutional investors with this ruling, you would not be alone. But for this ruling, virtually every shareholder agreement (in listed and unlisted public companies) that has a put or a call or a right-offirst-refusal clause, which nearly all of them have, would be at a risk not merely of not being able to enforce their rights, but also being held to have committed an illegality even though there is nothing speculative about such contracts. Such contracts allocate real-world rights wholly devoid of a speculative nature based on commercial underlying and consideration.
This writer had argued in the April 2011 piece that Sebi should reverse this law at short notice as it was dangerous for the economy and the investment climate and as it belongs to a Byzantine age of pointless suspicion of speculative contracts. The high court ruling gives comfort to literally tens of thousands of investment contracts and joint ventures. After giving up the argument of ‘forward contract’, the Sebi counsel attempted to argue that these were actually ‘option contracts or derivatives’ and were, therefore, illegal under Section 18A.
Since this wasn’t a ground of the order, the high court refused to look at it. In fact, the passing of Section 18A has nothing with creating a violation. It merely prevents onexchange futures and options from being termed a wager under the Contract Act. It does not conversely say all other off-exchange contracts are illegal.
Against this backdrop, it would be interesting to note that in the latest Budget, the finance minister has made a commitment towards deepening the capital markets in the country by allowing stock exchanges to host IPOs. This could only be served by allowing greater competition in the exchange space.
Disclosure: I have advised clients in the matter.
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