Synopsis
Shareholders’ Agreements are one of the definitive documents in case of an investment in a company. They are full of jargon which is often unintelligible to laymen and promoters signing without understanding them. This Article explains restrictive covenants, put options and veto rights found in Shareholders’ Agreements. It also analyses their validity under the Companies Act, 1956, the 2013 Act and the position for Listed Companies. Lastly, the Article examines the remedies for enforceability of such Agreements.
Introduction
Shareholders’ Agreements are one of the definitive documents which we witness in cases of an investment in a company by a Private Equity Fund, Foreign Direct Investor, etc. A Shareholders’ Agreement contains various restrictive covenants by theexisting promoters of the investee company, which usually are in the form of representations and warranties as well as promises to do or abstain fromdoing certain acts. These promises are important for the investor to invest in the investee company since they represent an assurance to him about hisexit route and other rights. One unique feature of Shareholders’ Agreements is that they are full of jargon which is often unintelligible to laymen.
Promoters, usually in a hurry to secure funds, end up signing on the dotted line of the Agreement without fully understanding the true repercussions of the Agreement. It is only later when these clauses materialise into reality that they wake up and smell the coffee but by then it is too late. Through this Article, let us understand better some of the important covenants which one come across in a Shareholders’ Agreement.
Restrictive Covenants
One or more restrictive covenants, such as, First Refusal, Tag Along, Drag Along, Russian Roulette, Texas Shoot-out, Dutch auction rights, etc., are usually found in Shareholders’ Agreement. These are briefly explained below:
(a) Right of First Refusal
This is the most common and easily understood covenant since it is found in the Articles of Association of all Private Companies. In case the Promoters desire to transfer any or all of their shares, the investor will have a Right of First Refusal, popularly called a RoFR, to purchase these shares. The pricing of the RoFR and the terms and conditions of the sale are the same as those that the promoter is offering to the prospective purchaser. In some cases, the promoter may also have a RoFR on the investor’s shares.
(b) Tag Along Rights
Tag along rights mean that if the promoters wish to sell their shares to anyone else, then the investor can tag along with them and offer its own shares. Example, a buyer has agreed to buy 50,000 shares from the promoter @ Rs. 100 per share. If the investor tags along with the promoter then either the buyer buys 50,000 from him also @ Rs. 100 or he buys 25,000 each from the promoter and the investor. Thus, the investor gets an exit if the promoter gets one. These are also known as piggy back rights since the investor piggy backs on the promoter.
(c) Drag Along Rights
On the other hand, drag along rights mean that if the investor wishes to sell his shares to a third party and if that third party also requires that the promoters should sell their shares, then the investor can drag along the promoters. Example, a buyer has agreed to buy 50,000 shares from the investor @ Rs. 100 per share. If the buyer wishes to buy more share as a pre-condition, then the investor can drag along with him the promoter and in that case the promoter must also sell the same number of shares at the same terms as the investor. Thus, if the buyer wants to buy out the whole company and not just the investor’s stake, then the drag along clause would enable an investor to facilitate such a transaction.
(d) Russian Roulette
Not very popular in India, a Russian Roulette clause means that “you buy me out or I buy you out”. The investor specifies a price at which either the promoter sells to him or buys the investor out. This is often resorted to when there is a deadlock situation.
(e) Texas Shoot Out
A third party is appointed as a Referee. Both the investor and the promoter submit bids to the Referee. Whichever is the higher bid wins and the winner must buy out the loser at that price. This is an extreme deadlock resolution mechanism.
(f) Dutch auction
A modification of the Texas Shoot out, in a Dutch auction also bids are submitted to a Referee. Only in this case the bids are for the minimum selling price. The winner must buy out the loser at the price quoted by the loser.
(g) Pre-emptive Rights
The investor has pre-emptive rights to participate in any future issuance (other than the current round) of equity (and other instruments convertible into equity) by the company on terms and at a price determined by the company but not less favourable than those offered by the company to any other investor, to retain its fully diluted equity shareholding in the company. The investor has a 20% stake in a company which has a capital of 1 crore shares. The company decides to increase its share capital by a further issue of 20 lakh shares. The investor must be offered 4 lakh shares out of this further issue so that it can maintain its holding of 20% in the post-issue capital of the company.
(h) Put Option
The investor has a right /option but not an obligation to sell its shares to the promoter of the investee company in case the company does not give it an exit in the form of an IPO /an Offer for Sale/Buyback of the investor’s shares. Thus, the promoters are bound to buy out the investor at a predetermined price or a pricing formula whichis specified upfront. This ensures an exit for the investor if all other methods fail.
The Supreme Court has recognised such rights in its decision in celebrated decision of Vodafone International Holdings, 341 ITR 1 (SC) and held as under:
“SHA, therefore, regulate the ownership and voting rights of shares in the company including ROFR, TARs, DARs, Preemption Rights, Call Options, Put Options, Subscription Option etc. in relation to any shares issued by the company, restriction of transfer of shares or granting securities interest over shares, provision for minority protection, lock-down or for the interest of the shareholders and the company. Provisions referred to above, which find place in a SHA, may regulate the rights between the parties which are purely contractual and those rights will have efficacy only in the course of ownership of shares by the parties.”
Validity of Restrictive Covenants under Companies Act, 1956
The Supreme Court has held that they are valid against a company only if they are a part of the Articles of Association or else they remain a private contract between shareholders – V.B. Rangarajan vs. V. Gopalkrishnan, 73 Comp. Cases 201 (SC). While thishas been the cornerstone for the law on Shareholders’ Agreements, the Supreme Court in Vodafone (supra) has taken a contrary view. The Concurring Order of J. Radhakrishnan, states in relation to Rangarajan’s judgment as follows:
“This Court has taken the view that provisions of the Shareholders’ Agreement imposing restrictions even when consistent with Company legislation, are to be authorized only when they are incorporated in the Articles of Association, a view we do not subscribe.”
Rangarajan’s decision was delivered by a Two-Member Supreme Court Bench, while Vodafone’s decision has been delivered by a Three-Member Bench, although the disagreement is expressed by the Concurring Judgment of one of its Members. It may be noted that the Vodafone decision has not expressly overruled Rangarajan’s decision.
Vodafone’s decision has further laid down that shareholders can enter into any Agreement in the best interest of the company, but the only thing is that the provisions shall not go contrary to the Articles of Association. The essential purpose of the Agreement is to make provisions for proper and effective internal management of the company. It can visualise the best interest of the company on diverse issues and can also find different ways not only for the best interest of the shareholders, but also for the company as a whole.
In the case of M.S. Madhusoodhanan vs. Kerala Kaumudi Pvt. Ltd., 117 Comp Cases 19 (SC) it was held that consensual agreements between shareholders relating to their shares do not impose restriction on transferability of shares and they can be enforced like any other agreement. Even if the company is a party to the Shareholders’ Agreement, the provisions relating to management of the affairs of a company cannot be given effect to unless the same are incorporated in its Articles of Association – IL &
FS Trust Co. Ltd vs. Birla Perucchini Ltd., 47 SCL 426 (Bom). Again, in Rolta India Ltd vs. Venire Industries Ltd., 100 Comp. Cases 19 (Bom), it was held that the shareholders cannot infringe upon the fiduciary rights and duties of directors. Any agreement by which the shareholders agreed not to increase the number of directors above a certain limit was not valid as long as the restriction was enshrined in the Articles of Association. The shareholders cannot dictate terms to directors except by amending the Articles. In Reliance Natural Resources Ltd. vs. Reliance Industries Ltd. [2010] 7 SCC 1, it was held that a Family Arrangement MOU executed by the key personnel of a listed company was held not to be binding on the company since the contents of the MOU were not made public. It was held that the MOU did not fall under the corporate domain – it was not approved by the shareholders. Therefore, technically, the MOU was not legally binding.
A Single Judge of the Bombay High Court, in the case of Western Maharashtra Development Corporation vs. Bajaj Auto Ltd., 154 Comp Cases 593 (Bom), had ruled that a Shareholders’ Agreement of a public company containing restrictive covenants was invalid since the Articles of a public company could not contain covenants restricting the trans-fer of shares and it was contrary to Section.108 of the Companies Act, 1956. Subsequently, a Division Bench of the Bombay High Court, in the case of Messer Holdings Ltd vs. Shyam Ruia, 159 Comp Cases 29 (Bom) has overruled this decision of the Single Judge of the Bombay High Court. The Bombay Court here was concerned with the validity of a Right of First Refusal Clause. The Court held that the intent of section 111A of the Companies Act, 1956 dealing with free transferability of shares does not in any manner hamper the right of its shareholders to enter into private treaties so long as it is in accordance with the Companies Act, 1956 and the company’s Articles of Association. Had the Companies Act, 1956 wanted to prevent such private contracts it would have expressly done so.
Interestingly, a recent decision of the Delhi Court in the case of World Phone India vs. WPI Group Inc, 119 SCL 196 (Del) has held that even a provision in the Shareholders’ Agreement which is not contrary to the Articles of Association or the Companies Act, 1956 cannot be enforced against the company if the company is not a party to such an Agreement. While it was settled law that in case of a conflict the Articles would prevail but this decision lays down that even if the Articles are silent on an issue and not in conflict, the provisions of the Shareholders’ Agreement cannot be enforced against the company.
Thus, the issue of Articles vs. Shareholders’ Agreement has yet not reached a finality.
Position under Companies Act, 2013
The Companies Act, 2013 now provides that securities in a public company are freely transferrable but a contract or an arrangement in respect of transfer of securities in a public company shall be enforceable as a contract. This express provision sets at rest once and for all whether public companies can contain pre-emptive rights. This is a big boost for Private Equity/FDI/Private Investment in Public Equity (PIPE) transactions since they almost always come with pre-emptive rights.
Position in the case of Listed Companies
It may be specifically noted that the Bombay High Court judgment in Messer Holdings (supra) was in the case of a listed company. Recently, the SEBI, taking a cue from the Companies Act, 2013, has issued a Notification under the Securities Contract (Regulation) Act, 1956, expressly permitting “contracts for pre-emption including right of first refusal, or tag-along or drag along rights contained in shareholders agreements or articles of association of companies”. Thus, these restrictive covenants can now expressly find their way even in Shareholders’ Agreements of Listed Companies, without the prior approval of the SEBI. It may be noted that even today the Articles of Association of several Listed Companies contain such pre-emptive rights.
The Notification further provides that even agreements for put and call options on listed securities are permitted subject to the following conditions:
(i) the title and ownership of the underlying securities is held continuously by the seller for a minimum period of 1 year from the date of entering into the contract;
(ii) the price or consideration payable for the sale or purchase of the underlying securities pursuant to exercise of any option contained therein, is in compliance with all the laws for the time being in force as applicable;
(iii) the contract is settled by way of actual delivery of the underlying securities; and
(iv) the contract shall be in accordance with the provisions of the Foreign Exchange Management Act, 1999 and Rules or Regulations made thereunder.
SEBI had in the cases of Cairn India Ltd., Vedanta Resources Plc. and Vulcan Rubber Ltd., held that an option arrangement in the case of shares of a listed company is not valid. This change in position is a welcome move.
Veto Rights/Affirmative Vote
Almost all investors want Veto Rights, i.e., certain specific fundamental issues, on which the company would not take a decision without the affirmative vote of the Investor. Thus, the Investor acquires a veto right on these issues. Some of the issues which may carry a veto include, alteration of the rights and privileges of the investor’s shares; change in the capital structure of the company; related party transactions with promoters in excess of certain limits; corporate reorganisation of the company; borrowing in excess of certain limits; change in the scope of the business; capital expenditure in excess of certain limit; commencement of any major litigation by the company; changes in key management personnel, etc.
By virtue of a veto, the investor has power to stall a decision of the company. However, in most cases, he does not have power to carry out a decision on his own behest. Thus, if he refuses the company cannot go ahead but if he proposes and the com-pany refuses then he cannot proceed on his own. A question often asked is that does the grant of such special rights make the investor a person in control of the company? This is a question of fact.
In the case of Subhkam Ventures (I) (P.) Ltd. vs. SEBI, 99 SCL 159 (SAT), the SAT held that the question to be asked in each case is whether the acquirer is the driving force behind the company and whether he is the one providing motion to the organization. If yes, he is in control but not otherwise. In short, control means effective control. In this case, the SAT held that the investor who had veto rights did not control the company. The SEBI contested it before the Supreme Court, where an interesting mutual consent agreement was arrived upon. The Supreme Court’s Order in SEBI vs. Subhkam Ventures, Civil Appeal No. 3371 /2010 states that certain facts changed after the SAT Order. Accordingly, the Court, by mutual consent, disposed of the appeal filed by SEBI by keeping the question of law open and it is also clarified that the order passed by the SAT will not be treated as a precedent. This leaves the all-important question yet open for interpretation. Some of the recent high-profile foreign takeovers/joint ventures have reportedly run into a roadblock with the SEBI on similar grounds. SEBI has questioned whether the grant of special investor protection rights to the foreign investor results into a sharing of management control with the Indian promoters?
Enforceability of Shareholders’ Agreement
A breach of a Shareholders’ Agreement would give rise to a suit for specific performance by the aggrieved party under the Specific Relief Act. However, in several cases, the Agreement itself provides that Arbitration would be the sole dispute resolution mechanism. It may further provide for Indian or Foreign Arbitration, e.g., in Singapore, London, Paris, etc.
In the case of Vodafone (supra), the Supreme Court held that the manner in which Shareholders’ Agreements are to be enforced in the case of breach is given in the general law between the company and the shareholders. A breach of such an Agreement which does not breach the Articles of Association is a valid corporate action but the aggrieved can get remedies under the general law of the land for breach of the Agreement and not under the Companies Act.
In the case of Chatterjee Petrochem (I) P Ltd vs. Haldia Petrochemicals Ltd., 110 SCL 107 (SC), an interesting issue arose. Certain disputes arose be-tween two sets of shareholders who were party to a Shareholders Agreement. The aggrieved party moved a petition for oppression u/s. 397 of the Companies Act, 1956. The Supreme Court held that in that case the breach of the Shareholders’ Agreement was a breach between two members of the company and not by the company itself. Hence, no occasion arises for filing a plea for oppression u/s. 397.
Conclusion
Shareholder Agreements have always attracted a lot of controversy and the spate of conflicting judgments have fueled the fire further. Parties to a Shareholders’ Agreement would be well advised to understand the implications of what they are getting into before signing such Agreements. Do Not Act in Haste and Repent in Leisure!!
