The author is Siddhaant Verma, a fourth year student at Jindal Global Law School.
With a vision to further liberalize its economy, India is trying to project itself as a pro-arbitration and pro-FDI regime. While a robust arbitration framework and increased foreign investment usually go hand-in-hand, Indian arbitration jurisprudence appears to be at odds with certain aspects of its exchange control rules. Such conundrums are most conspicuous in the enforcement of foreign arbitral awards. Foreign awards may entail payments or transfer of securities to foreign entities, which would invariably attract the regulatory hurdles of the Foreign Exchange Management Act, 1999 (“FEMA”) and the rules framed thereunder. This essay seeks to analyse the legal treatment of put option clauses in shareholder’s agreements. While put options offering assured returns to foreign investors are prohibited under the Foreign Exchange Management (Non-debt Instruments) Rules, 2019 (“NDI Rules”), Indian Courts have consistently affirmed such clauses in enforcement proceedings. I argue that a resort to arbitration is a problematic recourse for the enforcement of put options as courts and arbitrators have consistently made perverse findings. Instead, I outline a more nuanced regulatory framework to govern put options.
S. 3 of FEMA prohibits dealing in foreign exchange unless it is permitted by the Act. For regulating capital account transactions involving non-debt instruments, the Central Government notified the NDI rules in 2019. Rule 9(5) of the NDI rules provides that a foreign investor is prohibited from exiting under an optionality clause that provides for assured returns. The pricing guidelines under Rule 21 further reiterate that the guiding principle shall be that the foreign investor shall only be allowed to exit at the price prevailing at the time.
Equity investments by their nature are risk-prone and assured returns effectively alleviate the risk associated with the investment. India’s FDI policy seeks to prioritize long-term investments over short-term ones, as an equity investor is supposed to share both the reward and the risk, owing to the nature of the investment. A put option that guarantees an investor an assured return on exit disincentivizes long-term investments, as the foreign investor would easily be able to exit during periods of economic downturn. Nevertheless, India is perceived as a precarious market by investors, who require certain protective assurances before they are willing to invest. Thus, put options also play an important role in attracting foreign investors by providing them with a safety net against heavy losses. Therefore, the role of the Central Government should ideally be to balance the interests of investors with public policy concerns.
Regulatory Lacunae and the Resort to Arbitration
The current regulatory framework lacks nuance as it prohibits all put options, without striking the appropriate balance referred to above. This problem is evident in the NTT Docomo v. Tata case, wherein the RBI wanted to halt the indirect enforcement of a put option through an arbitral award. In Docomo, the impugned clause was in the nature of downside risk protection. Such clauses do not necessarily offer assured returns, but rather prevent the investor from incurring exorbitant losses. Docomo was not seeking to recoup the entire amount it had invested, but merely limit its losses to 50% of the sale price. Given the object of regulating such transactions, downside protection clauses should be permitted as they retain the element of risk while offering foreign investors important incentives. Due to the unwillingness of the RBI to condone such transactions, parties have to necessarily resort to arbitral proceedings to enforce their rights. While courts appear to be far more permissive in enforcing arbitral awards in violation of FEMA, there are several problems with this approach.
Firstly, the most obvious issue is that both parties to the transaction incur significant costs in going through arbitration proceedings. This significantly increases both the cost and the uncertainty related to foreign investment which could potentially act as a deterrent to attracting FDI. Secondly, courts have made questionable and sometimes contradictory interpretations of FEMA regulations. In the Docomo case for instance, the Court held that no RBI approval would be required as the award envisaged damages and not enforcement of the put option per se, even though it effectively involved the transfer of shares in return for money. This recharacterization of the transaction has allowed parties to circumvent a mandatory provision of FEMA. This would allow parties to structure exit options in a way where any shortfall between a pre-agreed price and the market value of shares is shrouded as indemnity/damages for breach of contract, to ensure that ‘assured returns’ do not come under RBI scrutiny.
In other cases, such as Cruz City, courts have instead held that while a violation of FEMA would not vitiate the award, subsequent approval of RBI would be required for any transfer of foreign exchange. The court also noted that proceedings could be initiated against the Indian party under FEMA, despite the validity of the award. Whether permission would be given by the RBI adds to the uncertainty of the parties, who would have spent a considerable amount of time and money on arbitration only to hit a roadblock with the RBI. Further, not only is the foreign party affected, but the enforcement of the award would also subject the Indian party to penal action. A more startling observation made in Vijay Karia was that a transaction may be condoned post-facto by the RBI, as breaches of FEMA are rectifiable. While FEMA does provide for the compounding of offences, this is in no way a condonation of the offence. Compounding differs from a settlement in that there is an admission of guilt involved in the former. This would not only cause reputational damage, but the Indian party can nevertheless be subject to financial penalties.
The decisional practice of enforcing courts is a quagmire with no discernible guiding principles. The regulatory lacunae in FEMA prohibiting all put-options has forced parties to opt for arbitration to enforce much-needed investor protections. While permission may be granted for enforcement by the RBI, their decisional practice shows their reluctance to do so, which leaves an arbitral award the only way for parties to exercise put options. This leads to absurd situations such as the one in Docomo, where parties were forced to arbitrate despite the absence of a dispute, as the RBI prohibited the parties from carrying out the transaction. However, the inconsistent and perverse findings of the courts have added to the uncertainty of parties, who are forced to spend a considerable amount of time and money waiting for judicial enforcement of their exit rights.
It is important for the RBI and the Central Government to realize that put options are essential to instill investor confidence. A blanket prohibition, clearly, does more harm than good. Given that the judicial trend is in favour of enforcing optionality clauses offering downside protection, the government should adopt a more nuanced framework for their regulation. There ought to be a distinction between a clause that offers downside protection and one that allows an investor to exit at a price higher than the sale price and prevailing market value. The RBI in Docomo realised this too, as it was initially inclined to permit the transaction, only for it to be thwarted by the Ministry of Finance. The RBI while processing Tata’s application for permission observed that the interpretation of the ‘assured return’ principle should be limited to those transactions where the investor “gets his entire principal PLUS a certain sum”. The author submits that this interpretation is the most appropriate one, which should be clarified in the NDI Rules.
There is a clear gap in the present regulatory framework governing put options. The lack of nuance in the FEMA leaves parties to rely on foreign arbitral awards to enforce their rights, which not only adds to their financial burden but also leaves the Indian party vulnerable to regulatory action. Further, a favourable arbitral award does not itself guarantee the enforcement of the put option as the parties would either have to seek RBI approval or the amount to be remitted outside India will have to be characterized as damages by the tribunal. Parties should not have to rely on costly adjudication to exercise put options. Thus, to boost investor confidence and realize India’s aspirations of becoming a truly liberalized economy, the Central Government needs to address the lacunae in its NDI Rules.