Distinguishing Downside Protection from Assured Exit Rights

A put option is a contractual right that entitles the option-holder to sell the underlying securities at a specific price, at a pre-determined time. In the Indian context, it is also used as an exit mechanism by foreign investors, whereby, upon occurrence of certain specified events, the company may be required to buy-back such option securities, or the promoters may be obligated to acquire them from the investors.

Legal Framework

The Indian foreign exchange law provides that a person resident outside India holding equity instruments in an Indian company may hold and exercise put options in Indian companies, subject to satisfying the minimum lock-in and the pricing guidelines prescribed.^[1] The law further states that persons resident outside India holding equity instruments in an Indian company cannot be guaranteed any assured exit price at the time of investment, and that such person shall exit at the price prevailing at the time of exit. ^[2]

Hence, a non-resident investor cannot be guaranteed an assured exit price at the time of making the investment, and the consideration payable to a non-resident investor at the time of exit cannot be more than the Fair Market Value (“FMV”) of the equity instruments at such time. Notwithstanding these regulatory constraints, Indian courts have weighed in on the enforceability of such clauses in various contexts.

Judicial Pronouncements

In the case of NTT Docomo Inc. v. Tata Sons Limited, ^[3] the shareholders’ agreement provided NTT Docomo Inc. (“Docomo”) a put option at an exercise price being the higher of (a) the FMV of the option shares as of a specified date, or (b) 50% of the price at which Docomo purchased such shares. The resultant arbitral award held that breach of contract by Tata Sons Limited entitled Docomo to damages equivalent to 50% of the price at which the shares were purchased by the investor. The Hight Court of Delhi upheld the award despite being challenged by the Reserve Bank of India on grounds of it being violative of the Foreign Exchange Management Act, 1999 (“FEMA”), holding that since the arbitral award was granted for payment of damages rather than for enforcing of put option, there was no violation of FEMA. Further, the court opined that the clause in the agreement that prevented Docomo from losing not more than 50% of its investment was in the nature of a downside protection and not an assured exit price.

In the case of Cruz City Mauritius v. Unitech Limited, ^[4] the shareholders’ agreement between the parties to the suit provided the petitioner-investor i.e. Cruz City 1 Mauritius Holdings (“Cruz City”) with a put option so as to yield Cruz City a post-tax IRR of 15% on the capital contributions made by Cruz City but only in one specific circumstance. If Unitech had failed to commence the project within the stipulated timeframe, the put option could be exercised by Cruz City but only within a limited exercise period.

The parties invoked the arbitration clause under the shareholders’ agreement, and an award was passed in favour of Cruz City. Unitech Limited (“Unitech”) opposed the enforcement of the said award, inter alia, on grounds that the enforcement would be contrary to the public policy of India as it violates the provisions of FEMA and contended that the shareholders’ agreement was structured in a manner so as to provide an assured exit to Cruz City from its investment in an overseas company. The Delhi High Court held that the put option could not be construed as an open-ended assured exit option at a pre-determined return, since it was capable of being exercised only upon the occurrence of a breach, and within a specified time period which amounts toa downside protection arrangement rather than a mechanism to guarantee assured return. The Delhi High Court further observed that the RBI’s circular dated January09,2014 ^[5] which prohibits optionality clauses granting assured returns on Foreign Direct Investment would not be applicable in situations where a foreign investor bases its claim in breach of contract.

Conclusion

While the legal framework prohibits assured returns, Indian courts (such as in Docomo and Cruz City) have distinguished between (i) downside protection and contractual damages, and (ii) assured exit price. As such, when it comes to cross-border investments, suitably structured downside protections can survive regulatory scrutiny and provide foreign investors with a much-needed solution to the assured exit restrictions under FEMA.

References

[1] Explanation (i) of Rule 2(k) read with the Explanation of Rule 21(2)(c)(iii), Foreign Exchange Management (Non-Debt Instruments) Rules, 2019

[2] Rule 21(2)(c)(iii) Explanation, Foreign Exchange Management (Non-Debt) Rules, 2019

[3] NTT Docomo Inc. v. Tata Sons Limited, 2017 SCC OnLine Del 8078

[4] Cruz City Mauritius v. Unitech Limited, 2017 SCC OnLine Del 7810

[5] RBI/2013-2014/436, A.P. (DIR Series) Circular No.86, Foreign Direct Investment – Pricing Guidelines for FDI Instruments with Optionality Clauses

accessible at <https://www.rbi.org.in/scripts/NotificationUser.aspx?Id=8682&Mode=0>

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