There is some interesting debate on the recent Sebi mandate to Vedanta-Cairn to repudiate a call/put/pre-emptive rights in their share purchase agreement. Sebi's stand is both interesting and dangerous. However, Sebi is mainly the messenger of an archaic law. And the message deserves to be shot. Luckily, Sebi owns the handgun that is capable of quickly shooting down this quixotic law.
The problem arises out of a section of the Securities Contracts (Regulation) Act, 1956 which enables the government, Sebi or the RBI to ban certain contracts in securities. In a different philosophical era, the government, suspicious of the evils of speculation banned all such forwards and options contracts in securities by a circular of 1969. The circular was drafted in the double negative and thus exceedingly broad, i.e., it banned all contracts which were not spot delivery contracts.
Thus, anything which was not a spot delivery contract, where securities and cash were exchanged on the date of the agreement to purchase, would be illegal. This 1969 law was replaced by a Sebi circular of 2000 continuing the ban. In theory, the ban applied all these years to even non-speculative rights between shareholders, i.e., right to buy securities in the future or forward contracts or even an option to buy in the future. The width of the prohibition has been clarified by a 1997 Supreme Court ruling, which found certain contracts in an unlisted public limited company to be illegal because they were forward contracts.
Many law firms have given opinions in the past saying such rights were legal, based on their understanding of what a forward contract is or what a non-spot contract is. The party seems to have ended with the Sebi mandate to Cairn-Vedanta to delete such a right from its agreement. There are indications that Sebi will prohibit such clauses in other agreements in the future, though it is not clear if it will take enforcement action against signatories to such contracts.
While the law is reasonably clear in its prohibition, and deliciously vague in its exemptions, its late application raises questions about the desirability of such a law. While the prohibition is overly broad, there are exemptions provided in the Act, by cases and by a circular. Of non-spot transactions, the Act exempts exchange-traded derivatives obviously, as also convertibles and warrants.
Cases have interpreted the law to exclude private limited company from the purview of the Act, and thus the prohibition applies to not only listed companies but also to unlisted public companies. Why a ban on unlisted securities contracts is useful is anyone's guess. Finally, a 1961 circular exempts certain types of pre-emption rights heavily qualified with vague language as to its applicability. The short opinion thus is that the law is not merely silly but also very dangerous.
The rationale for not continuing with the law in today's economy is clear. First, speculation is no longer a dirty word, and nearly all economists today would agree that speculators not only provide liquidity and price discovery in the market, but often offer trades on the other side of hedgers. In other words, if speculation was to be banned, traders who want to hedge their trades would be worse off and frequently be left without the ability to hedge their risk.
Second, most trades in the secondary market (particularly exchange-traded futures) can be categorised as speculative. Why ban one type of speculative contracts and not others? Assuming that on-exchange speculative transactions are more desirable for some reason, shareholder contracts are not even speculative in nature, they allocate real world rights wholly devoid of a speculative nature based on commercial underlying and consideration. The width of the prohibition on non-spot or forward trades makes such non-speculative contracts illegal. This is really unintended and if implemented, would literally render millions of investment agreements, private equity deals, joint venture agreements and other commercial contracts partially illegal.
Luckily for us, the answer to this law of unintended consequences is not to go through the long route of parliamentary approval. If Sebi chooses to reverse this law, it can do so at short notice as a delegatee of the power by Parliament. Since there is only a Sebi law in the way by way of its circular of 2000, Sebi is empowered to rescind it.
At the very least, Sebi needs to exclude non-speculative forwards, call/put options, buy-backs, right of first refusal, pre-emption rights in commercial agreements from the scope of the prohibition. Ideally, Sebi should completely withdraw the circular which just belongs to an age when we followed a suspicious thinking about speculators and the very evil dark-glasses-wearing-gold-smugglers.
(The author is the founder of Finsec Law Advisors)
The problem arises out of a section of the Securities Contracts (Regulation) Act, 1956 which enables the government, Sebi or the RBI to ban certain contracts in securities. In a different philosophical era, the government, suspicious of the evils of speculation banned all such forwards and options contracts in securities by a circular of 1969. The circular was drafted in the double negative and thus exceedingly broad, i.e., it banned all contracts which were not spot delivery contracts.
Thus, anything which was not a spot delivery contract, where securities and cash were exchanged on the date of the agreement to purchase, would be illegal. This 1969 law was replaced by a Sebi circular of 2000 continuing the ban. In theory, the ban applied all these years to even non-speculative rights between shareholders, i.e., right to buy securities in the future or forward contracts or even an option to buy in the future. The width of the prohibition has been clarified by a 1997 Supreme Court ruling, which found certain contracts in an unlisted public limited company to be illegal because they were forward contracts.
Many law firms have given opinions in the past saying such rights were legal, based on their understanding of what a forward contract is or what a non-spot contract is. The party seems to have ended with the Sebi mandate to Cairn-Vedanta to delete such a right from its agreement. There are indications that Sebi will prohibit such clauses in other agreements in the future, though it is not clear if it will take enforcement action against signatories to such contracts.
While the law is reasonably clear in its prohibition, and deliciously vague in its exemptions, its late application raises questions about the desirability of such a law. While the prohibition is overly broad, there are exemptions provided in the Act, by cases and by a circular. Of non-spot transactions, the Act exempts exchange-traded derivatives obviously, as also convertibles and warrants.
Cases have interpreted the law to exclude private limited company from the purview of the Act, and thus the prohibition applies to not only listed companies but also to unlisted public companies. Why a ban on unlisted securities contracts is useful is anyone's guess. Finally, a 1961 circular exempts certain types of pre-emption rights heavily qualified with vague language as to its applicability. The short opinion thus is that the law is not merely silly but also very dangerous.
The rationale for not continuing with the law in today's economy is clear. First, speculation is no longer a dirty word, and nearly all economists today would agree that speculators not only provide liquidity and price discovery in the market, but often offer trades on the other side of hedgers. In other words, if speculation was to be banned, traders who want to hedge their trades would be worse off and frequently be left without the ability to hedge their risk.
Second, most trades in the secondary market (particularly exchange-traded futures) can be categorised as speculative. Why ban one type of speculative contracts and not others? Assuming that on-exchange speculative transactions are more desirable for some reason, shareholder contracts are not even speculative in nature, they allocate real world rights wholly devoid of a speculative nature based on commercial underlying and consideration. The width of the prohibition on non-spot or forward trades makes such non-speculative contracts illegal. This is really unintended and if implemented, would literally render millions of investment agreements, private equity deals, joint venture agreements and other commercial contracts partially illegal.
Luckily for us, the answer to this law of unintended consequences is not to go through the long route of parliamentary approval. If Sebi chooses to reverse this law, it can do so at short notice as a delegatee of the power by Parliament. Since there is only a Sebi law in the way by way of its circular of 2000, Sebi is empowered to rescind it.
At the very least, Sebi needs to exclude non-speculative forwards, call/put options, buy-backs, right of first refusal, pre-emption rights in commercial agreements from the scope of the prohibition. Ideally, Sebi should completely withdraw the circular which just belongs to an age when we followed a suspicious thinking about speculators and the very evil dark-glasses-wearing-gold-smugglers.
(The author is the founder of Finsec Law Advisors)
