Veto or affirmative rights are designed to prohibit an investee company from acting on matters which are meant to protect the value of an investor's investment without the approval of the investor. While such a right is intrinsically expected to provide certain level of control to the investor, the Delhi High Court in its recent judgment in World Phone India Ltd. v. WPI Group Inc. appears to have diluted the efficacy of this right and added to the already existing controversy regarding investor rights in shareholders' agreements.
In this case, a board meeting of the company approving a rights issue was sought to be invalidated on the ground that consent of one of shareholders who had an affirmative vote under the terms of a joint venture agreement was not taken. The Delhi High Court held that where the articles are silent on the existence of an affirmative vote requirement, it will not be possible to hold that a clause in an agreement between the shareholders would be binding on the company. The Court further elaborated that the law does not contemplate that clauses in an agreement which are not reflected in the articles of the company to be enforceable just because such clauses are not repugnant to the Companies Act, 1956 (Act) – what is needed first and foremost is the existence of such a clause in the articles of association. To understand the rationale behind the judgment, it is worthwhile to look at the different approaches taken by the judiciary on this point in the past.
In the context of share transfers, the commonly held view is that a contractual arrangement imposing a restriction on transfer of shares in a private company is valid so long as the same is incorporated in the articles of that company. This is a longstanding view based on the landmark decision in the case of V.B. Rangaraj v. V.B. Gopalakrishnan where the Supreme Court held that any restriction on transferability of shares of a company shall not be binding on the company unless incorporated in its articles. Equally worthy of merit is the Madhusoodhanan case where the Supreme Court has, without overruling the decision in, but distinguishing the facts from, the Rangaraj case held that the while a restriction on transfer of all shares of a company was void in the absence of such restriction being incorporated in the articles, an agreement between particular shareholders relating to the transfer of specified shares is valid. It has further been observed that it is not necessary for the company to be a party to any agreement relating to the transfers of shares for such agreement to be specifically enforced between the parties to the transfer.
Reiterating the principle set out in the Rangaraj case and taking it a step further, the Bombay High Court, while dealing with restrictions on resignation of directors set out in the shareholders' agreement, held that the provisions in an agreement cannot be given effect to insofar as the management of the affairs of the company is concerned, unless such provisions are incorporated in the articles of association of the company. On the same principle, the Gujarat High Court denied a claim for exercising pre-emptive rights of a shareholder as the same were not incorporated in the articles of the company.
Unfortunately, these cases do not shed any light on the validity of investor protective covenants vis-à-vis the shareholders who have entered into an agreement to safeguard such rights. However, two contrary decisions passed by the Bombay High Court merit discussion here - overruling its earlier judgment, the Bombay High Court held that arrangements entered into by shareholders must prevail as long as it is in conformity with the Act and are not in conflict with the articles of the company. The Bombay High Court has relied on two decisions of the Supreme Court where it was observed that consensual arrangements between particular shareholders relating to their shares can be enforced like any other agreement and is not required to be embodied in the articles of association. However, based on the Rangaraj decision, it will not bind the Company. In a lesser known case, the Company Law Board has, while dealing with the affirmative vote of a shareholder in relation to a rights issue, also observed that the shareholders are not prevented from enforcing the agreement for breach of the agreement or for a specific performance in appropriate cases.
In the background of the existing body of precedents, it appears that the current legal position is that while an investor can seek remedies in the nature of damages or injunction for a breach or proposed breach of its affirmative rights, a resolution, which is otherwise passed in accordance with the Act and is not repugnant to the articles of the company, cannot be nullified on the ground of it being in violation of the shareholders' agreement. The investor may not have a remedy against the company even if the company is a party to the shareholders' agreement, and in fact, if one were to take a strict and conservative view, the provision in the shareholders' agreement which purports to bind the company may itself be held to be invalid. What is slightly more concerning is that the investor may not have an effectual remedy against other shareholders on whom the shareholders' agreement is binding and potentially one may be left with only a claim for damages for breach of the agreement.
Even assuming that any and every matter in relation to the corporate affairs or management of a company needs to be incorporated in the articles for it to be valid and binding on the company, the question that remains is even if such protective provisions are incorporated in the articles, will they stand the test of voidness if it conflicts with the Act?
Authors: This article has been authored by Kosturi Ghosh, who is a partner and Ipsita Chowdhury, who is an associate at the Bangalore office of Trilegal. Kosturi heads the corporate practice group in Bangalore and her area of expertise is private equity and venture capital investments.
Disclaimer: The contents of this article are intended for informational purposes only and do not constitute legal opinion or advice. Readers are requested to seek formal legal advice prior to acting upon any of the information provided herein.
Trilegal is one of India's leading law firms with offices in four of India’s major cities - Mumbai, New Delhi, Bangalore and Hyderabad. The firm has the experience and expertise in acting on complex, high-value, cross-border as well as domestic transactions, leading to its key practices winning top industry awards and accolades. The firm’s key practice areas include private equity and venture capital; corporate - mergers and acquisitions, strategic alliances and joint ventures, projects, energy and infrastructure, banking and finance, restructuring, capital markets, telecoms, media and technology, dispute resolution, competition law, labour and employment, real estate and taxation. Trilegal is recognised as having a market leading practice with a client base that includes leading international and Indian companies as well as smaller growing businesses. The firm’s client roster comprises many of the world's leading funds, corporations, banks and financial institutions. http://www.trilegal.com
World Phone India Ltd. v. WPI Group Inc.  178 CompCas 173 (Delhi)
AIR 1992 SC 453
M.S. Madhusoodhanan v. Kerala Kaumudi Pvt. Ltd. and Ors.  117 CompCas 19 (SC) and S
IL and FS Trust Co. Ltd. v. Birla Perucchini Ltd.  121 CompCas 335 (Bom)
Mafatlal Industries Ltd. v. Gujarat Gas Co. Ltd. and Ors.  97 CompCas 301 (Gujarat)
Western Maharashtra Development Corpn. Ltd. v. Bajaj Auto Ltd.  154 CompCas 593 (Bom) Messer Holdings Limited v. Shyam Madanmohan Ruia and Ors.  159 CompCas 29 (Bom) Madhusoodhanan case (supra) and S.P. Jain v. Kalinga Tubes AIR 1965 SC 1535
Jiji Antony and Ors. v.JRG Securities Limited and Ors. 161 CompCas 304 (CLB)
Venture Intelligence is the leading provider of data and analysis on Private Company Financials, Transactions (private equity, venture capital and M&A) & their Valuations in India. Click Here to view our products list including the Free Deal Digest Weekly: India's First & Most Exhaustive Transactions Newsletter.