Shareholders Agreement: A key to protection of rights of shareholders

This article delves into the significance, components, and legal implications of shareholders’ agreements, highlighting their crucial role in corporate governance and the protection of shareholder interests.

ABSTRACT

A shareholders’ agreement serves as a vital tool for companies with multiple investors, providing a framework for regulating rights and responsibilities, particularly in key decision-making processes. While typically established during company formation, such agreements can evolve as new investors come on board. They stand distinct from company bylaws, focusing squarely on safeguarding shareholders’ interests, outlining their rights, and delineating their obligations within the company’s framework.

Ideally, the agreement should be formulated during the company’s inception or initial share issuance, facilitating a shared understanding among entrepreneurs or investors regarding contributions and expectations.

In essence, shareholders’ agreements play a pivotal role in shaping corporate governance and protecting shareholder interests. Their adaptability allows for the accommodation of evolving business landscapes and shareholder dynamics. However, their efficacy hinges on legal compliance and alignment with statutory requirements, highlighting the need for thorough legal review and strategic drafting. As such, they serve as indispensable tools for fostering transparency, accountability and harmony among stakeholders within a company.

The purpose of this research paper on shareholders’ agreements is to provide a comprehensive understanding of their significance, components, and legal implications in corporate governance. It aims to elucidate how shareholders’ agreements function as vital instruments in protecting the interests of both businesses and shareholders.

By examining the key components and provisions typically found in shareholders’ agreements, the paper seeks to underscore their role in delineating rights, obligations, and decision-making processes within a company. Furthermore, it aims to explore how these agreements can safeguard minority shareholders who may have limited control over business operations.

Keywords: company law, shareholder’s agreement

INTRODUCTION

SHAREHOLDER’S AGREEMENT

The agreement amongst shareholders regarding the transfer of shares is known as a shareholder’s agreement. Since this agreement places various limitations on the transferability of shares, the primary concern at first was how it went against the idea of the unrestricted transferability of shares.

These are essentially private contracts that provide rights and obligations for each shareholder toward the others. Unlike the company’s other documents, this one is private and signed by two people without the involvement of the corporation, therefore it is not open to public inspection. The foundation of shareholder agreements is the idea that shares are freely transferable, which gives the shareholder the option to decide how to transfer their shares, including whether or not to impose restrictions. In Vodafone International Holdings B.V. v. Union of India, J. Radhakrishnan provides the greatest explanation of the true essence of a shareholder’s agreement.[1]

“A shareholders’ agreement, or just SHA for short, is a contract that a company’s shareholders enter into with the intention of imposing obligations and conferring rights beyond those stipulated by company law. In contrast to the company’s public Articles of Association, the SHA is a private agreement between the shareholders. Since it is a private instrument, only the parties involved are bound by it—the remaining stockholders. SHA offers more flexibility than Articles of Association, which is an advantage. It also specifies how any disagreements among the shareholders will be resolved and how future capital contributions must be paid. The Articles of Association’s clauses may also conflict with SHA provisions.”[2]

Therefore, relationships between shareholders and between shareholders and the corporation are governed by the shareholders agreement. Numerous elements, such as the entitlement to special voting rights and other authorities, are included in these agreements.

Court rulings pertaining to the shareholders’ agreement

The case of V B Rangaraj v. V B Gopalakrishnan[3] is the most significant one in terms of shareholder agreements because it was decided by the honorable Supreme Court, whereas other decisions are decided by the high courts of various states. In one instance, a private company’s shareholders came to an agreement that forbade them from transferring shares to anyone who is not related to them. In this case, the Supreme Court examined the Companies Act and determined that the Articles of Association alone regulate the relationship between the company and its shareholders. If there isn’t an express agreement in the Articles of Association, it cannot be enforced in a court of law. However, if this legal interpretation is to be upheld, then the shareholders’ agreement serves no purpose at all, since every restriction must be stated in the articles of association. Subsequently, a significant case was Mafatlal Industries Ltd. v. Gujarat Gas[4], where the court, J. Shah, adhered to the Rangarajan case’s precedent. In the current instance, Mafatlal was a stakeholder in a publicly traded firm. He transferred some shares to Jardine Fleming, and the two of them signed a contract giving Mafatlal the right of first refusal. It is notable that this agreement was excluded from the company’s Articles of Association. Fleming later sold the shares to a few other people without making an attempt to sell Mafatlal the shares. The High Court heard the case when Mafatlal sued him. Additionally, he argued that while constraints imposed by third parties are related to the unrestricted transferability of shares, a shareholder may impose restrictions on himself through agreements and other means. Fleming argued that the act and the association’s articles are the only places where restrictions on the free transferability of shares can be placed, and that the provisions pertaining to this freedom are not susceptible to contracts to the contrary. The court accepted this argument and held that the only distinction between a private and public company is that the former’s articles of association contain a provision restricting the transfer of shares, whereas the latter do not. As a result, public companies are also covered by the Rangarajan case.

The Bombay High Court then heard the case of IL and FS Trust Co. Ltd. v. Birla Perucchini Ltd. In this instance, the plaintiff sought to prevent the respondent from admitting additional individuals—who are also respondents—resigning from their positions as the company’s directors. The court in this instance upheld the Rangarajan ruling, ruling that the only document governing relationships among shareholders is the Article of Association. As a result, the agreement was not deemed legally enforceable. The court further declared that any arrangement not expressly included in the Articles of Association shall not be binding on the corporation or its shareholders.

The next significant case that came before the Honorable Supreme Court was Madhusudan v. Kerala Kaumudi[5]. In the current instance, a private company’s shareholders agreed that, upon the chairman’s passing, her shares would be divided 50:25:25, with a shareholder by the name of Madhu being entitled to 50% of the shares. Following the chairman’s passing, Madhu filed a claim for specific performance because the 50% of the shares had not been transferred to her. The defendants in this case argued that there is no specific relief available in this case and that the ruling in the Rangarajan case applies. After analyzing the Kalinga Tubes case, the court in this instance concluded that there are significant differences between the two types of share transactions. In the latter scenario, the company’s only requirement is to acknowledge a new shareholder. The court further declared that, as far as legal binding authority was concerned, the shareholders’ agreement was not distinguished from other agreements in the Kalinga Tubes case. After distinguishing the case from the Rangarajan case, the court concluded that any shareholder may sell their shares to any third party, subject to the restrictions contained in the articles of association, and that these agreements may be expressly enforced. The court further found that where the item is not readily available on the market, one of the requirements outlined in section 10 of the Specific Relief Act must be met. Therefore, the court decided that it could be specially enforced because private business shares are not readily available on the market.

The Delhi High Court’s Pushpa Katoch v. Manu Maharani[6] case is the next significant one. In the current instance, the four sisters came to an understanding that the first sister to offer her shares to the other sisters would do so if she wanted to get rid of them. However, in this instance, one sister sold her shares without giving them to the other four sisters, and as a result, it came before the CLB. The High Court heard the case after CLB dismissed it. In this instance, the court only cited section 111A of the act to rule that a public company’s shareholders are not subject to any limitations regarding the transferability of their shares. The court also opined that had there been any such restriction then it would have been ultra vires the act.

The Bombay High Court’s latest significant case is Western Maharashtra v. Bajaj Auto[7]. In this instance, the parties had a protocol that said that when one party sells its shares, the other party will have the right of first refusal and that the price will either be predetermined or determined by an arbitrator. Subsequently, Western made a share offer to Bajaj, and a price arbitrator was appointed. Western then contested the arbitrator’s jurisdiction, claiming that it violated section 111A of the statute. The high court noted that a private business cannot restrict the transferability of its shares like a public company does by definition. Pre-emptive clauses are illegal because they invariably have the effect of restricting the unrestricted transferability of a company’s shares. The court further stated that even if the agreement had been included in the articles of association, it would have been ultra vires because it would read section 111A of the act as subject to a contract to the contrary, which is not possible with a statute.

The Reasons Behind the Conclusion of a Shareholders’ Agreement

There are a number of reasons why a shareholders’ agreement can be concluded “before” or “alongside” a company agreement. The following are the most common ones:

a) In order to facilitate the least troublesome foundation for the company, it is customary to arrange for the collaboration of potential future members during the potentially protracted time before the company agreement concludes (or later, if a new member joins, for example). Even though it isn’t an agreement to agree, the shareholders’ agreement in this instance is a “preparatory” contract. Setting up the company’s funds by the members with non-monetary donations is a common component of this preparation. An accountant or accountants must be involved in the prior appraisal of donations in kind since it is a complex matter that could affect the future power dynamics within the organization, particularly in the case of intellectual property. (The parties should also establish regulations, such as what to do in the event that the court rejects some portions of the in-kind contributions, etc.)

b) Most of the time, the shareholders’ agreement continues to be in effect throughout the duration of the business’s operations and is not dissolved upon the company’s establishment. The shareholders’ agreement in this instance demonstrates the qualities of a framework agreement, including provisions pertaining to the conduct of the members with regard to the organization and operation of the company for the entirety of the company’s existence. For example, votes may be cast at the general shareholders’ meeting to elect the minority member’s candidate to the supervisory board or to name each member’s candidate to the board of directors.

Is The Shareholders’ Agreement In Listed Companies Enforceable Or Just Legal Fiction?

The common belief is that shareholder agreements (“SHAs”) become inactive when a company lists since the shareholding structure of the business changes significantly.

Though there are some limitations, examining the legislation and regulations reveals the opposite.

A listed company is required by SEBI LODR, 2015 Regulation 4(2)(d)(i) to respect the interests of its shareholders as defined by law or by mutual agreement. The following is the pertinent excerpt:

“(i) The listed entity shall respect the rights of stakeholders that are established by law or through mutual agreements.”

In the context of public companies, the proviso to Section 58(2) of the Companies Act, 2013 recognizes rights established through mutual agreements regarding the transfer of securities. This proviso stipulates that “any contract or arrangement between two or more persons in respect of transfer of securities shall be enforceable as a contract.”

According to SEBI and the Companies Act, the rights of stakeholders—including shareholders—are recognized. These rights are thought to have been developed through mutual agreements, which includes shareholder agreements.

Consequently, the rights contained in a company’s AoA and SHA do not end just because the company issues equity shares for public purchase.

It is pertinent to mention herein that provisions of SHA without being incorporated in the AOA, though may be enforced against the other shareholders, but would not be binding on the Company.

Certain rights under SHAs have occasionally endured even after listing; the two most prominent examples are Jet Airways (India) Limited and Interglobe Aviation Limited.

Even when Interglobe Aviation Limited (the “Indigo”) goes public, its Promoter Group is still entitled to certain things under the shareholders’ agreement outlined in the AoA.

Under the terms of the AoA and the shareholders’ agreement dated April 23, 2015, as amended by the agreement dated September 17, 2015, Indigo entered into agreements with the following parties: IGE, Acquire Services, Mr. Kapil Bhatia, Mr. Rahul Bhatia, and Ms. Rohini Bhatia (collectively, the “IGE Group”), and Caelum Investment LLC, Mr. Rakesh Gangwal, Ms. Shobha Gangwal, and The Chinkerpoo Family Trust (collectively, the “RG Group”), who are entitled to the following rights:

(i) Three directors were up for nomination from the IGE Group and one from the RG Group; one director from each group was a non-retiring director.

(ii) The IGE Group had to propose a candidate for chairman of the board, and

(iii) Subject to compliance with Indian law, which mandates that any such appointment be approved by the shareholders at a shareholders’ meeting in the case of the Managing Director, and by the Board in the cases of the Chief Executive Officer and the President, the IGE Group had the right to nominate and appoint the Managing Director, the Chief Executive Officer, and the President of Indigo.

(iv) The other group shall have the right of first refusal and tag along right in the event that any member of the RG Group or the IGE Group proposes to transfer its shares to a third party purchaser (who need not be an affiliate) in any manner other than through a pre-negotiated sale on a stock exchange.
IGE Group and RG Group were permitted to use these rights up to November 9, 2019, which is four years after the IPO. However, because of some disagreements amongst the promoters, the RoFR clauses remained enforceable even after that. An EGM was summoned in response to a ruling by the London Court of International Arbitration, and the aforementioned clause was removed following the EGM’s vote.

As a result, it is clear that some provisions of shareholder agreements may stay in effect even after a public offering and that certain shareholders may still be able to exercise their rights under them.

SEBI has, nevertheless, suggested some modifications to the current system. In addition to seeking to strengthen corporate governance at listed entities by giving shareholders the authority to address a number of issues, including the issue of special rights granted to certain shareholders, the Consultation Paper[8] suggests introducing measures to protect the interests of minority shareholders, including the Equitable Treatment, right to receive dividends, and ability to participate in share buyback. The fundamental idea is that any entitlement not available to other shareholders will not be allowed to continue after listing, and the shares issued in the initial public offering (IPO) will rank equally with the existing shares.

CONCLUSION

In conclusion, shareholders’ agreements serve as indispensable instruments in shaping corporate governance and protecting shareholder interests. They offer a framework for regulating rights and responsibilities among shareholders, particularly in decision-making processes, beyond what is provided by company bylaws. Despite their significance, court rulings have highlighted the importance of aligning these agreements with statutory requirements, emphasizing the need for thorough legal review and strategic drafting.

Through an examination of key components and provisions typically found in shareholders’ agreements, this research paper underscores their role in delineating rights, obligations, and decision-making processes within a company. Furthermore, it explores how these agreements can safeguard minority shareholders who may have limited control over business operations.

Collisions between shareholders’ agreements and company agreements, particularly regarding confidentiality, choice of law, and limiting the mandatory nature of company law, pose challenges that require careful consideration during drafting and implementation. While shareholders’ agreements provide flexibility and adaptability to evolving business landscapes and shareholder dynamics, their effectiveness ultimately relies on legal compliance and alignment with statutory requirements.

In essence, this paper provides a comprehensive understanding of the significance, components, and legal implications of shareholders’ agreements in corporate governance, highlighting their pivotal role in fostering transparency, accountability, and harmony among stakeholders within a company.

REFERENCES

• Vodafone International Holdings B.V. v. Union of India (2012) 341 ITR 1 (SC).
• Ibid, at para 154.
• V B Rangaraj v. V B Gopalakrishnan (1992) 1 SCC 160.
• Mafatlal Industries Ltd. v. Gujarat Gas (1999) 97 Comp Cas 301 (Guj. HC).
• Madhusudan v. Kerala Kaumudi (2004) 9 SCC 204.
• Pushpa Katoch v. Manu Maharani (2006) 131 Comp Cas 42 (Delhi HC).
• Western Maharashtra v. Bajaj Auto (2010) 154 Comp Cas 593 (Bom.).
• Consultation Paper On Strengthening Corporate Governance At Listed Entities By Empowering Shareholders – Amendments To The SEBI (LODR) Regulations, 2015 Dated 21.02.2023

[1] (2012) 341 ITR 1 (SC).

[2] Ibid, at para 154.

[3] (1992) 1 SCC 160.

[4] (1999) 97 Comp Cas 301 (Guj. HC).

[5] (2004) 9 SCC 204.

[6] (2006) 131 Comp Cas 42 (Delhi HC).

[7] (2010) 154 Comp Cas 593 (Bom.).

[8] Consultation Paper On Strengthening Corporate Governance At Listed Entities By Empowering Shareholders – Amendments To The SEBI (LODR) Regulations, 2015 Dated 21.02.2023

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Author: Jayani Banerjee | Christ (Deemed to be University), Pune