Enforceability of Shareholders Agreements: In Relation to Articles of the Company

Enforceability of private arrangements entered into by shareholders often become a bone of contention in corporate disputes. Following is an attempted analysis of the judicial trend in that regard in this country. While referring to the judgments, it is important to look into the factual matrix of the cases, as the reasoning would vary depending upon the nature of the company (private or public) and the status of the agreements (whether or not incorporated in the Article). Rhodes scholar and subsequently Vinerian scholar designate V. Niranjan did a brilliant and elaborate analysis of this issue in the Indian Corporate Law Blog (http://indiacorplaw.blogspot.in/2010/09/rangaraj-madhusoodhanan-conflict-and.html). I've reproduced the article below with some minor alterations and additions.

1. Introduction

Contracts among shareholders of a company are termed as “shareholders agreements” (SHA). Usually, the company is also a party to these agreements (but this may not always be the case) which confer rights and impose obligations over and above those provided by company law. The agreements provide for matters such as restrictions on transfer of shares (right of first refusal, right of first offer), forced transfers of shares (tag-along rights, drag-along rights), nomination of directors for representation on boards, quorum requirements and veto or supermajority rights available to certain shareholders at board level or shareholder level. Hence, broadly, Shareholders Agreements provide stipulations either for transferability of shares (restriction, forced transfer, etc) or they provide conditions which govern the administration of the company.

2. Judicial Trend on Enforceability of Shareholders Agreements.

2.1. Shareholders Agreements dealing with Transferability of Shares.

As mentioned earlier, Shareholders Agreements may either contain provisions on transferability of shares or deal with aspects of corporate governance (voting rights, quorum, etc). However, most of the judgments delivered by the courts in India are on situations wherein SHAs have dealt with transferability of shares under Section 111A of the Indian Companies Act.

2.1.1. Stage 1: Non Enforcement due to absence of provisions in Articles.

Initially, the Indian courts did not favour complete freedom of contract in the case of shareholders agreements. Courts either refused to recognize clauses in shareholders agreements or, even when consistent with company legislation, enforced such clauses only if they were incorporated in the articles of association.

(Niranjan's analysis extracted from his post in the Indian Corporate Law Blog link to which is mentioned above)
"The landmark judgment in this regard is V.B. Rangaraj v. V.B. Gopalakrishnan, AIR 1992 SC 453, [1992] 73 Comp. Cas. 201, often cited in the context of shareholders’ agreements. The defendant in that case was a private limited company, and in time, its sole shareholder came to be a family that consisted of two branches. The principals of each branch orally agreed in 1951 that the proportion of shareholding of their respective branches would not change, and provided, for this purpose, that any member of a branch who wished to sell his shares must first offer the shares to his own branch. After referring to the decision of the Supreme Court in Kalinga Tubes, common law decisions and scholarly opinion, Sawant J. held that shares are “freely transferable” and that “a private agreement that imposes … restrictions not stipulated in the articles of association…” is “not binding either on the shareholders or on the company. Hence, in this judgment, the Apex Court refused to enforce shareholders agreement which provided for restriction in transferability, as it had not been stipulated in the Articles. The statutory ground of the decision was S 82 which provides that shares in a company constitute movable property “transferable in the manner provided by the articles of association”.

The Rangaraj rule was reiterated in Mafatlal.

(Niranjan's analysis extracted from his post in the Indian Corporate Law Blog link to which is mentioned above)

Ø  "Mafatlal Industries Ltd. v. Gujarat Gas Co. Ltd., [1999] 97 Comp. Cas. 301 (Gujarat High Court)

In 1999, an eminent judge of the Gujarat High Court heard Mafatlal, where the defendant was a public limited company. The plaintiff had sold 3.87 % of the equity in that company to an FII with a pre-emption right, who later disposed of a part of those, shares in the open market. The plaintiff relied on the right of pre-emption to invalidate the subsequent sale by the FII, and argued, interestingly, that “free transferability of shares refers to absence of restrictions which may be imposed by third parties, but it cannot exclude the right of a shareholder to impose restrictions on himself in the matter of transfer of shares to another person.” This argument was rejected by M.B. Shah J., who pointed out that the “ratio in the case of V.B. Rangaraj will apply with much greater force to the case of a public company”."

2.1.2. Stage 2: Enforcement despite absence of provisions in Articles.

Subsequently, the courts moved on from taking the Rangaraj rule as a blanket provision on enforcement of shareholders agreement, to applying it on given factual scenarios. The judgments which distinguished Rangaraj are the following:

(Niranjan's analysis extracted from his post in the Indian Corporate Law Blog link to which is mentioned above)

Ø  "M.S. Madhusoodhanan and Anr. v. Kerala Kaumudi (P) Ltd. and Ors. 2004) 9 SCC 204

In 2002, the Supreme Court decided Madhusoodhanan. The case arose out of a complex family dispute in Kerala, and specifically out of a karar (agreement) that provided in Clause 2 that “there would be no change in the existing share structure” (among the family) of a private company. Clause 2 also provided that the shares of two members would pass to Madhusoodhanan in a certain percentage on their death. Ruma Pal J. distinguished Rangaraj and Kalinga Tubes on the basis that this restriction was not on a share as a class, but on specific, identified shares between specific, identified members, to which the company need not be a party. Whether the decision is consistent in its entirety with Rangaraj is a matter of disagreement, especially as to the clause that there would be no change in the existing share structure – a provision similar to the requirement in Rangaraj that the shareholding pattern of the two branches would remain constant. Therefore, even if the company is not a party to the shareholders agreement, that by itself does not prevent the shareholders, inter se, from enforcing their agreement in relation to the transfer of shareholding.

However, it is clear that it is not authority for the general proposition that a private arrangement is legal under existing Indian law, but at best for the proposition that a transaction between identified members imposing a restriction on identified shares is legal.

Ø  This brings us to the two Bombay High Court decisions. In Western Maharashtra Development Corpn. Ltd. v. Bajaj Auto Limited, [2010] 154 Comp. Cas. 593 Chandrachud J. noted that the karar in Madhusoodhanan had dealt with specific, identified shares between identified members, followed Rangaraj, and declared that a right of pre-emption is contrary to s. 111A. That has now been overruled in Messer Holdings [2004] 121 Comp. Cas. 335.  In Messer, Khanwilkar J. makes three points – first, that the legislative history of s. 111A shows that the intention of the legislature was to fetter the actions of the Board of Directors, not individual shareholders; secondly, that Madhusoodhanan is authority for the general proposition that “consensual arrangements between particular shareholders relating to their specific shares do not impose restriction on the transferability of shares”; and thirdly, that “freely transferable” in s. 111A only means that “both seller and purchaser must agree to the terms of the sale”. It was further held that this need not be embodied in the articles of association.

In paragraph 55, Khanwilkar J. held as follows:

…“freely transferable” in Section 111A does not mean that the shareholder cannot enter into consensual arrangement/agreement with the third party (proposed transferee) in relation to his specific shares If the company wants to even prohibit that right of the shareholders, may have to provide for an express condition in the Articles of Association or in the Act and Rules, as the case may be, in that behalf.

The rule in Rangaraj was that a restriction on the transfer of shares is “unenforceable unless contained” in the Articles of Association. If Messer Holdings is good law, the rule is that a restriction on the transfer of shares is “enforceable unless barred” by the Articles."

It is important to note that Messer is at present in appeal before the Apex Court.

2.2. Shareholders Agreements dealing with issues of Corporate Governance.

These agreements have acquired popularity in the Indian context only over the last two decades or so. Therefore, courts have not been presented with sufficient opportunities to decide upon the enforceability of their provisions. Where courts have indeed ruled on such agreements, it has often been in relation to agreements merely stipulating transferability of shares and not on issues of governance. However, there have been three judgments of the Delhi High Court which have dealt with the issue of enforceability of agreements in relation to issues other than transferability.

Ø  Spectrum Technologies USA v. Spectrum Power Generation Company. 2000(56)DRJ405

In this case the Respondent Company contended that they would not be bound by the Promoters Agreement as they were not a party to it. The Delhi High Court refused to entertain the plea because the company had passed a board resolution to implement it in the Articles and taken such steps which were required of the Agreement, hence expressing their intent to abide by its terms. The provisions of the Agreement were also not inconsistent with the Articles or memorandum although the provisions of the promoters’ agreement were never incorporated in the Articles.

Para 22.

“We are unable to agree with the submission advanced on behalf of SPGL that adoption and revocation of the said promoters’ agreement by SPGL are irrelevant to the issue on hand. As regards the three decisions referred to above, in none of these decisions the company had agreed to amend its Articles of Association to bring them in conformity with the promoters’ agreement and, Therefore, they being distinguishable are inapplicable to the facts of the present case. “

Ø  Modi Rubber Ltd. v. Guardian International Corp. 2007(2)ARBLR133(Delhi)

In this case the Petitioner and Respondent entered into a shareholders’ agreement to collaborate and promote a joint venture company for the production and marketing of float glass. Subsequently the financial status of the petitioner company drastically deteriorated and it was declared to be a ‘sick company’ by the BIFR. As a result, the respondent proposed to set up a wholly owned subsidiary, without the consent of the petitioner, in breach of clause 14 of the Shareholders Agreement. The Respondent argued that since the said clause was not incorporated in the Articles of the joint venture company, they were not to abide by it. The Delhi High Court negating the argument ruled in favour of the petitioners and prevented the respondent from proceeding towards setting up of the said subsidiary. However, it seems from the order, that the Shareholders Agreement was enforced despite not being incorporated in the Articles because the said clause was merely a non compete clause and had nothing to do with the administration of the company. In fact, Sr. Arun Jaitley, senior counsel for the appellant, sought enforceability of the agreement on the aforementioned ground.

Para 61.

“Mr. Arun jaitley, learned senior counsel for the petitioner, has urged that clause 14 of the SHA did not relate to a matter effecting the affairs of the joint venture.”

Para 68.

“The instant case is certainly not concerned with any restriction or stipulation relating to management of the affairs of GGL, the joint venture. The agreement between the parties relates to an agreement not to enter into such business which is the same as or similar to the business of GGL, the company that is the joint venture. There is a fundamental difference between such an agreement as against an agreement relating to restriction on transfer of share holding or functioning as directors of a company which would be governed by the Companies Act and the Articles of Association of the company.”

Hence, According to the judgment, the demarcation of shareholders agreement on the basis of what they ought to achieve is irrelevant and whether they deal strictly with transferability or governance, they must not be in conflict with the Articles.

Ø  Premier Hockey Development v. Indian Hockey Federation 2011(2)ARBLR492(Delhi)

The Shareholders Agreement required a minimum quorum requirement which was not met. The petitioner contended that such requirement was invalid since the said provision was not incorporated in the Articles. Reliance was placed on the Rangaraj judgment by the petitioners. The court negating the contention held in favour of the Respondents while distinguishing Rangaraj on the following grounds:

a. The petitioner company, unlike in Rangaraj, was a party to the agreement.

Para 36.

“Pertinently, the position in the case in hand is materially different from that before the Supreme Court in Rangaraj (supra). The Petitioner company is a party to the Subscription and Shareholders Agreement dated 31.12.2004.”

b. the petitioners could not show any clause in the SHA which were in conflict with the articles.

Para 39.

“In the present case as well, there is no Article pointed out by the Petitioner, in the Articles of Association of the Petitioner company, which conflicts with Articles 10.3.2 and 10.3.3 of the Subscription and Shareholders Agreement.”

However, as mentioned earlier, the relevance of the above judgments may be limited to the extent that it is only a High Court decision and the extensiveness of the principle cannot be taken for granted unless the Supreme Court echoes that view.

3. Analysis of the judgements.

An analysis of the above judgements on the issue of shareholders agreement seem to be that they shall be enforced, even if not incorporated in the Articles, provided they are not in conflict with it.

As regards enforceability against the company:

a. they shall be enforced if the company is a party to it.

b. they shall not be enforced if the company isn’t a party (Rangaraj hasn’t been overruled), provided the company hadn’t expressed its willingness to amend its articles to implement it in its Articles (such as passed a Board Resolution). This follows from the Spectrum ruling.

As regards enforceability against the parties:

they shall be enforced even if the company isn’t a party to it or even if it is not incorporated in the Articles, provided they are not in conflict with the Articles or any statutory provision. (Modi Rubber, Messers Holdings).

The Present Position in light of the Vodafone Verdict:

The Supreme Court’s judgment in Vodafone (2012) is of enormous importance to a number of branches of Indian law. The relevant para in context of shareholders agreement is reproduced below:

SHAREHOLDERS' AGREEMENT

154. shareholders' Agreement ( for short SHA) is essentially a contract between some or all other shareholders in a company, the purpose of which is to confer rights and impose obligations over and above those provided by the Company Law. SHA is a private contract between the shareholders compared to Articles of Association of the Company, which is a public document. Being a private document it binds parties thereof and not the other remaining Advantage of SHA is that it gives greater flexibility, unlike Articles of Association. It also makes provisions for resolution of any dispute between the shareholders and also how the future capital contributions have to be made. Provisions of the SHA may also go contrary to the provisions of the Articles of Association, in that event, naturally provisions of the Articles of Association would govern and not the provisions made in the SHA.

155. The nature of SHA was considered by a two Judges Bench of this Court in V.B. Rangaraj v. V.B. Gopalakrishnan and Ors. MANU/SC/0076/1992 : (1992) 1 SCC 160. In that case, an agreement was entered into between shareholders of a private company wherein a restriction was imposed on a living member of the company to transfer his shares only to a member of his own branch of the family, such restrictions were, however, not envisaged or provided for within the Articles of Association. 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.

Conclusion:

To guarantee enforcement, while it is not necessary that the provisions of the shareholders agreement are to be incorporated in the Articles, it is certainly to be ensured that such provisions are not in conflict with the Articles.