Under the Indian Companies Act, shareholders do not run any company, only the directors do. It is recognized that the directors represent the interests of the shareholders. Shareholders’ Agreement can outline who can appoint directors, how they are to be appointed and what percentage is required to remove a director. The right to appoint a director gives you control over how the company will be run and provides an assurance to you that there will a director on board who understands your position as a minority shareholder.
A Shareholders’ Agreement is a legally binding contract between the shareholders and the company, as well as between each shareholder of the company. The agreement governs the shareholders, their business relationships and arrangements, and also sets out the shareholders’ rights, responsibilities, liabilities and obligations. There are many provisions contained within a Shareholders’ Agreement to ensure that each shareholder is treated fairly.
The shareholders in the case of a private limited company are restricted to transfer their shares to maintain the shareholding patter under control of majority shareholders. The restriction is applicable on both majority as well as minority shareholders. These rights are conferred by the Articles of Association (‘AOA’) of the company and the Companies Act, 2013 to the shareholders of private limited company. The minority shareholders restrict the exits of management or an investor from the company by enforcing these rights. Therefore, an investor while at the time of investing in a private limited company needs some rights to be included in the Shareholding Agreement to secure his exist and the investment. Generally, in case of private limited companies, many rights are available to shareholders through its AOA.
A shareholders’ agreement will normally prohibit a shareholder from selling their shares without first giving the other shareholders a reasonable opportunity to buy them. These provisions are known as ‘pre-emptive rights’. The basic idea is to ensure that the existing shareholders cannot be forced to accept an unwanted new shareholder.
Generally, the existing shareholders will have the right to buy the exiting shareholder’s shares:
a. in proportion to their existing shareholdings (unless the agreement gives priority to a particular shareholder or shareholders); and
b. at a price that is not lower than the price offered to any potential third-party buyer.
Other than above, the “drag along” and “tag along” provisions are a classic example of a balancing act between the rights of a majority shareholder and a minority shareholder. It is submitted that these rights are considered to be an important part of any term sheet/shareholders’ agreement that involves the transfer of equity shares. The above rights are put in place during investment negotiations between a company’s majority shareholder and minority shareholders.
The “drag along” and “tag along” are contractual and do not find any place under the Indian Companies Act. The same has been discussed in the matter of Vodafone International Holdings BV v. The Union of India, (2012) 6 SCC 613 wherein, the Supreme Court said that inter-alia tag along and drag along rights are contractual which are biding no matter whether they are mentioned in the AoA of the company or not. The only precaution that needs to be taken is to make sure that shareholders’ agreement is not violative of anything in the AoA.
Section 111A of Companies Act, 1956 states that the shares in the public company must freely be transferable. Which means that there cannot and should not be any restriction on transfer of shares to one party to another. Section 58 of Companies Act, 2013 follows the same line of reasoning but also additionally came with the clause that states:-
“Provided that any contract or arrangement between two or more persons in respect of the transfer of securities shall be enforceable as a contract.”
Section 111A of Companies Act, 1956 was implicit about the separate contractual arrangement of parties whereas Section 58 of Companies Act, 2013 has made it very explicit that parties may individually enter into separate contractual arrangements.
Drag Along provision in shareholders’ agreement (Right to Majority Shareholders)
A drag along provision allows the majority shareholder(s) to require the minority shareholder(s) to sell their shares. The aim of drag along rights is to provide liquidity, flexibility and an easy exit route for a majority shareholder. As many buyers of a target company will want 100% control over the business and rarely agree to allow minority shareholders to retain a minority shares, it would be difficult for majority shareholders to accept an offer if the minority shareholders are uncooperative and block the sale of a company. Drag along rights are triggered in all types of sales transactions such as mergers and acquisitions, or a change of control in the company.
Drag along rights benefit the majority shareholders cum promoters. An incoming investor might wish to acquire full control over the company. Minority shareholders may not wish to tag along and wish to stay with the limited ownership in the hope that share prices may rise. Majority shareholders/Promoters, therefore, include “drag along rights” provision in the term sheet/shareholders agreement that gives them the power to compel the minority shareholders to sell off their shares at a price determined for majority selling shareholders on the same terms and conditions.
In instances when there is a bidder who would like to buy the entire company, and the majority shareholder(s) holding more than 50% of the company agree to sell their shares, the majority shareholder(s) can “drag along” the remaining minority shareholder(s) and require the minority shareholder(s) to sell their shares so the bidder is able to purchase the entire company.
This provision prevents any future situation in which a minority shareholder has the ability to block the sale of a company that was already approved by the majority shareholder or a collective majority of existing shareholders.
Generally, a shareholder with non-controlling interest i.e. minority shareholder is not able to negotiate a provision that allows him to prevent a liquidation or sale. However, sometimes, transaction require unanimous consent for sale as stipulated in agreement or otherwise. In this case, a majority shareholder’s drag-along right supersedes the governing agreements and allows him to force a sale of the company.
It is also pertinent to note that while drag-along rights are meant to protect the majority shareholder of a company, they are also beneficial for minority shareholders. Since this type of provision requires that the price, terms and conditions are homogenous across the board, small equity holders can realize favorable sales terms that may be otherwise unattainable.
It is also pertinent to note that sometimes drag along provisions will be coupled with a pre-emptive rights clause, so that the minority shareholders have the right to buy the entire venture rather than being forced to work with a new third party buyer.
Tag Along provision in shareholders’ agreement (Right to Minority Shareholders)
Tag along rights are also known as ‘co-sale rights’ are simply those rights which mostly benefit the minority shareholders. When the promoters or Majority shareholders transfer their shares to incoming investors, the existing minority shareholders can tag along. It means that they can bind the selling shareholders to allow the minority shareholders to sell their shares along with them on the same terms and conditions. Tag along provisions are usually worded to state that if the tag along procedures are not followed then any attempt to buy shares in the company is invalid and would not be registered.
More specifically, if the majority shareholder(s) wants to sell shares to a third party, and does not provide notice to the other shareholders, the tag along provisions will enable the minority shareholder(s) to tag along with the majority shareholder(s) and sell its shares for the same price and on the same terms and conditions. In a well-drafted and well-balanced Shareholders’ Agreement when a shareholder wishes to sell its shares, the shareholder is normally required to provide notice to the other shareholders. This requirement is usually contained within a “first right of refusal” clause.
Please note that minority shareholder can protect their rights by incorporating this clause in the Shareholders’ Agreement.
‘Right of First Refusal’ clause in shareholders’ agreement
This is a right which requires any existing shareholder who wishes to sell their shares to first offer it to other existing shareholders on a pro-rata basis to maintain percentage ownership. Having this right means that, as a minority shareholder, you will be given the opportunity to purchase these shares, before they are released to any individual or entity outside of the company.
Enforceability of provisions contained in shareholders’ agreement
Please note that rights mentioned above are rights which if not mentioned specifically in AOA, would come under the ambit of Contract laws of India. In India, picture has not been clear regarding with Pre-emptive Rights, First Right of Refusal, Tag Along, Drag Along and Put and Call options.
One of the first judgments of the Supreme Court on enforcement of contractual restrictions on the transfer of shares, is the landmark case of V.B. Rangaraj vs. V.B. Gopalkrishnan and others on 28th November, 1991 (Rangaraj Judgment), wherein the court, relying on Section 82 of the Companies Act, 1956 [82. Nature of shares. The shares or other interest of any member in a company shall be movable property, transferable in the manner provided by the articles of the company], held that a restriction which was incorporated in the Shareholder’s Agreement, but not specified in the Article of Association, was not binding either on the company or the shareholders.
Subsequent judgements after ‘Rangaraj Judgement’ had either followed the above reasoning or made an attempt to distinguish the facts of the cases from existing precedent of ‘Rangaraj Judgement’.
1. In the case of Messer Holdings Limited v. Shyam Madanmohan Ruia and Ors. 2010(5) Bom CR 589 dated 1st September, 2010, the divisional bench of Bombay High Court distinguished the case from ‘Rangaraj Judgement’.
The Court further referred to Western Maharashtra Development Corporation Ltd. v. Bajaj Auto Ltd., (2010) 154 Company Cases 593 (Bom) where a single judge had observed that Rangaraj Judgement case only deals with a matter involving a private company, and therefore the said judgement and its ruling shall not be applicable in a matter involving Public Ltd. Company. The Bombay Court held that any clause in an agreement which restricts the free transfer ability of shares of public companies is void and non- enforceable, even if such restrictive clause is incorporated in the Articles of Association of the company.
The primary question before the court involved an interpretation of section 111A of the Companies Act 1956 which as the court ruled does not explicitly restrict or take away the right of shareholders to enter into consensual arrangement or agreement in respect of shares held by them. In this regard the court also enunciated that shareholders did have the freedom to enter into consensual agreements which were not in conflict with the AoA of the Company or with the existing legislations governing companies.
2. Three-Judge Bench of Supreme Court of India dealt with the ratio of ‘Rangaraj Judgement’ again in Vodafone International Holdings BV v. The Union of India, (2012) 6 SCC 613 dated 20th January, 2012 and specifically disagreed with the reasoning. The Hon’ble Court said:
“(62). 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 shareholders in the company. 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.
“(63) The nature of SHA was considered by a two Judges Bench of this Court in V. B. Rangaraj v. V. B. Gopalakrishnan and Ors. (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….
“(64) Shareholders can enter into any agreement in the best interest of the company, but the only best interest of the company, but the only thing is that the provisions in the SHA shall not go contrary to the Articles of Association. The essential purpose of the SHA is to make provisions for proper and effective internal management of the company. It can visualize 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…..
“(66) 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.”
The Hon’ble Court directly did not overrule ‘Rangaraj Judgement’ but clearly expressed its disagreement with the reasoning therein. The court said that inter-alia tag along and drag along rights are contractual which are biding no matter whether they are mentioned in the AoA of the company or not. The only precaution that needs to be taken is to make sure that shareholders’ agreement is not violative of anything in the AoA.
The Apex Court held that shareholders could enter into any arrangement in the best interests of the Company, as long the provisions of shareholder Agreement were no contrary to the articles of the Company. Further it held that in the event of breach of terms of shareholder agreement (which were not breach of terms of AOA), the aggrieved shareholder could pursue legal action as per the law of the land.
The Apex Court’s observations in this case further clarified the stance of the courts on the issue of conflicting provisions in a shareholder agreement and AoA. It was stated that the restrictions imposed under shareholder agreement provisions, though in compliance with the applicable laws, are to be enforceable only when incorporated in the AoA.
Please note that the said case is one of the most recent cases from the apex court that precisely talks about Tag along and Drag along rights.
3. After the Vodafone International Holdings case it was felt that the issue has been settled but in 2013 in another case which was decided by Hon’ble Delhi High Court created ripples in the water. In re World Phone India Pvt. Ltd v. WPI Group,  178 Comp Cas 173 (Del),the issue involved a resolution passed by the board of directors of a private company relating to the rights issue. But such resolution required an affirmative vote of the appellant as per shareholders’ agreement. The same was not exercised. The court said since such right is not mentioned in the AoA, it is not enforceable solely based on shareholders’ agreement.
The Delhi High Court in its recent judgment in World Phone India (P.) Ltd. v. WPI Group Inc., USA held that where the AOA of a company are silent on the existence of an affirmative vote, it would not be possible to hold that a clause in an agreement between the shareholders would be binding without being incorporated in the AoA.
In this case, the board of directors of the company passed a resolution approving a rights issue in accordance with the AoA of the company, even though such an action required the affirmative vote of the Appellant in accordance with a shareholders’ agreement entered into between the shareholders of the company. The Company Law Board had held that since the provisions of the shareholders granting an affirmative vote to the appellant were not incorporated in the AOA, the said provision is unenforceable and the board resolution approving the rights issue was valid. On appeal, the Delhi High Court held as follows:
“…the question to be asked is whether the provisions of an agreement, that are not inconsistent with the Act, but are also not part of the articles of association, can be said to be applicable. All that section 9 states is that the clauses in the agreement that that “repugnant” to the Act shall be “void”. This does not mean that the clauses in the agreement which are not repugnant to the Act would be enforceable, notwithstanding that they are not incorporated in the articles of association.”
In view of the above, it would be pointless to have a shareholders’ agreement in the first place qua the AOA, since every clause in the agreement would have to be incorporated in AOA. Unless the clear picture comes out from the Apex Court, it is advisable to incorporate clauses of shareholders’ agreement in AOA either by insertion or by reference in AOA. Further, it is clear that Pre-emptive rights, Tag-along, Drag along, Put/call options and Right of first refusal are enforceable rights in India.
Disclaimer: Nothing contained in this document is to be construed as a legal opinion or view of either of the authors whatsoever and the content is to be used strictly for educative purposes only.