A put option was held to be more like a downside protection – A Protection for Shareholders of Private limited Companies

Put Options under the Companies Act, 2013, and Its Compliances

The Companies Act, 2013 governs the enforceability and regulation of put options in agreements related to shares of companies, including private limited companies in India. This provision, when coupled with relevant rules and regulatory frameworks such as FEMA and SEBI guidelines, ensures the legal validity and compliance of such contracts.

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Legal Validity of Put Options

1. Definition and Concept:
   • A put option is a contractual right granted to a shareholder (e.g., an investor) to sell their shares to another shareholder (e.g., a promoter) at a pre-agreed price or under specified conditions.
   • It offers downside protection or an exit mechanism to the shareholder.
2. Recognition Under the Companies Act, 2013:
   • Section 10 of the Companies Act recognizes the freedom of shareholders to enter into agreements related to their shares, provided these agreements do not contravene the provisions of the Companies Act or other laws.
   • Put options, being contractual agreements, are enforceable provided:
     • They comply with the Companies Act.
     • They do not amount to an unfair restriction on share transfers.
3. Historical Context:
   • The Securities Contracts (Regulation) Act, 1956 (SCRA) initially disallowed put and call options on shares as “void.” However, the amendment of the SCRA and SEBI Circular dated October 3, 2013, clarified that such options are valid if they comply with specific conditions.

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Compliances for Put Options

1. Companies Act, 2013:
   • Section 6: The Companies Act overrides any conflicting terms in a shareholders’ agreement unless those terms comply with the Act.
   • Articles of Association (AoA):
     • The AoA must explicitly permit the transfer of shares under a put option.
     • The agreement must align with the AoA to avoid challenges to enforceability.
   • Section 42 (Private Placement):
     • If the shares are being repurchased as part of the put option, the transaction must comply with private placement rules.
2. Valuation Compliance:
   • The price at which the put option is exercised must adhere to fair market valuation principles to ensure fairness.
   • In cases involving foreign investors, FEMA pricing guidelines apply (see below).
3. Stamp Duty and Share Transfer:
   • Appropriate stamp duty must be paid on the share transfer under the put option.
   • The share transfer form (Form SH-4) must be executed and filed.

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FEMA Compliances (for Foreign Investors)

1. Pricing Guidelines:
   • The transfer price of shares must comply with FEMA’s fair market value (FMV) principles.
   • A qualified valuer determines the FMV.
2. Sectoral Caps:
   • Put options must respect sectoral caps under FEMA regulations (e.g., in sectors where FDI restrictions apply).
3. Timelines for Payment:
   • The payment for shares must comply with FEMA regulations on remittance timelines.

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SEBI Guidelines (if applicable)

For companies where SEBI regulations are relevant (e.g., if institutional investors are involved):

1. October 2013 SEBI Circular:
   • Put and call options are valid if:
     • The exercise of the option is not in contravention of the Companies Act, FEMA, or other laws.
     • The contract specifies the option price or formula for determining it.

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Tax Implications

1. Capital Gains Tax:
   • Any gain arising from the transfer of shares under a put option is subject to capital gains tax as per the Income Tax Act, 1961.
   • The tax rate depends on the holding period of the shares (short-term or long-term).
2. Transfer Pricing:
   • If the transaction involves related parties, transfer pricing regulations may apply to ensure arm’s-length pricing.

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Practical Example:

Scenario:

• An investor invests ₹5 crore in a private limited company and negotiates a put option to sell their shares back to the promoter at ₹6 crore after three years if the company underperforms.

Compliances:

1. The agreement specifies the conditions for exercising the put option and aligns with the AoA.
2. If exercised:
   • A share transfer form (SH-4) is filed.
   • Valuation is obtained to ensure compliance with FEMA/Companies Act pricing guidelines.
   • Capital gains tax is calculated based on the transaction.

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Challenges and Risks:

1. Enforceability:
   • If the agreement conflicts with the AoA or Companies Act provisions, it may be deemed unenforceable.
2. Liquidity Concerns:
   • The buyer under the put option must have sufficient liquidity to honor the agreement.
3. Valuation Disputes:
   • Disputes may arise over the FMV of shares, particularly in high-growth or volatile sectors.

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Conclusion:

Put options are legally valid under the Companies Act, 2013, provided they are structured and executed in compliance with:

• Provisions of the Companies Act and Articles of Association.
• FEMA regulations (if applicable).
• SEBI guidelines (where relevant). By ensuring proper documentation, valuation, and compliance, put options can effectively serve as risk management tools or exit mechanisms in private limited companies.