Enforceability of Special Rights: A Brief Companies Act, 2013 Perspective
[Harshit Anand works at Khaitan & Co, Kolkata, and deals with real estate and corporate matters. He may be reached at firstname.lastname@example.org.]
In most Joint Venture Agreements (JVAs), parties retain certain special rights- more commonly referred to as veto rights- with respect to general meetings and board meetings. These veto rights, amongst others, are affirmative rights which provide for the mandatory presence of a party or parties to the JVA whenever a resolution is being passed or a decision is being taken. In other words, veto power gives an entity the power to reject a proposal even in cases where the proposal enjoys the support of the majority. This article makes an attempt to analyse the enforceability of such special/veto rights of those shareholders who are equity holders but do not enjoy voting power by virtue of their below 50% ownership of the equity capital under the Companies Act, 2013 (the Act). Staying true to the principles of corporate democracy, the Act in its entirety accords special protection to minority shareholders and it needs to be seen whether such minority shareholders, who do not enjoy voting rights under ordinary circumstances, can have access to such special rights.
By virtue of Section 5 of the Act, a company derives its powers and takes directives for management from its Articles of Association (Articles). Section 10 of the Act dictates that the Articles bind the company and its members and, therefore, all the provisions of the Articles have to be complied with accordingly. Usually, when a joint venture company (JV) is brought into existence, special rights such as compulsory presence to form quorum and required affirmative vote for a resolution to pass successfully are transferred from the JVA to the Articles of the JV. Although termed as veto rights in common parlance, these rights usually work towards protection of each of the parties or any of the parties by blocking the formation of quorums or the successful passing of resolutions, thus functioning in the nature of reverse veto rights in the practical sense.
Special rights in light of World Phone India Pvt. Ltd. and Others v. WPI Group Inc., USA (World Phone)
In World Phone, a JVA was executed in 1999 in which special rights appertaining to affirmative vote were given to the chairman of World Phone India Group of the USA (WPI US) in all matters related to World Phone India Private Limited, the JV. Such terms of the JVA were not incorporated in the Articles of the JV. WPI US, holding 43.75% of the total paid up equity share capital of the JV, was a minority shareholder in the JV. A board meeting of the JV was held in 2010 (notice of which was sent to the chairman of WPI US) in which rights issue of shares was approved. Due to some unforeseen circumstances, the chairman could not attend such meeting and WPI US filed an application before the Company Law Board (CLB) to declare the aforementioned meeting void.
The CLB passed an interim order restricting the effect of the resolution and a consequent appeal was filed in the Delhi High Court against the aforementioned order of the CLB. The issue before the High Court was whether an affirmative right granted in the JVA can be enforced against the JV, even if it is not incorporated in the Articles of the JV. The High Court held that in the absence of incorporation in the Articles, such rights are unenforceable, thereby setting aside the interim order of the CLB which recognized affirmative voting rights. A subsequent Special Leave Petition was filed in the Supreme Court which was dismissed, as the Court felt that the High Court had already opined on the interim relief passed by the CLB, and any other dispute between the parties would fall under the scope of adjudication by the CLB.
The observations of the High Court in this case are noteworthy. The High Court held that Section 9 of the erstwhile Companies Act of 1956, which is Section 6 of the Act, has an overriding effect over the Articles of a company. The underlying jurisprudence of the erstwhile Section 9 makes it clear that special rights, if not incorporated in the Articles, are not binding and clauses in the memorandum, Articles, JVA or resolution, if in contravention with the Act, shall be void. The doctrine of identification propounded by the Supreme Court in Reliance Natural Resources Limited v. Reliance Industries Limited, which states that actions of the key personnel should be deemed as actions of the company, was rejected by the High Court. The High Court chose to rely on V.B. Rangaraj v. V.B. Gopalakrishnan and Ors., in which it was held that, unless the Articles are amended, the terms of an agreement cannot be held to be enforceable. The Court further relied on IL and FS Trust Co. Ltd. v. Birla Perucchini Ltd. to hold that applicability of V.B. Rangaraj is not limited to ‘transfer of shares’. WPI US had the opportunity to get the Articles amended but they did not go for the same.
In In re: Jindal Vijayanagar Steel Limited, a petition was filed for confirmation of alteration of the memorandum to give effect to shifting of the registered office. It was argued that the JVA warranted consent of the nominee director to shift the registered office which was not given. The CLB confirmed the alteration done to the memorandum, thereby holding that the requirement of consent of the nominee director was not put down in the Articles and, therefore, was not binding. Hence, if the requirement of consent is put down in the Articles, it would be in conflict with Section 17 of the erstwhile Companies Act of 1956 and would become void by the operation of Section 9 of the said legislation.
In Messers Holdings, the High Court held that a consensual agreement between the shareholders of a company restricting transfer of shares is valid unless specifically barred by the Articles. In Gharda Chemicals, it was held that a restriction on transfer of shares in a public company is in contravention with the provisions of the erstwhile Companies Act. Thus, a restriction on transferability of shares in a public company would be void even if put down in the Articles.
In Vodafone, it was observed that the Supreme Court does not adhere to the view in Rangaraj, in the sense that the restrictions in a shareholders’ agreement, although consistent with the erstwhile Act, are to be authorised only when put down in the Articles of the Company. However, Rangaraj was not categorically overruled. A breach of the shareholders’ agreement which does not breach the Articles would be a valid corporate action and the aggrieved parties would be able to get remedies under the general law of the land for any breach of the given agreement, but not under the erstwhile Act.
Entrenchment Clause in the Act
Entrenchment provisions have been added in the Act to lend support to the vulnerable parties and to not allow arbitrary decision-making in the company. Decisions will not be taken until the consent of such vulnerable members, if provided for in the entrenchment clauses of the Articles, is taken. Section 5(3) of the Act provides for conditional entrenchment provisions in the Articles, which would mean that specific provisions can be changed subject to fulfilment of certain conditions or compliance with specific procedures. These provisions in the Articles provide the minority shareholders room to manoeuvre and unconditionally bargain with the majority shareholders. Entrenchment clauses also ensure that the company does not become a slave to the whims and fancies of a few powerful shareholders. Once the provisions for special rights are entrenched in the Articles, the minority shareholders can compel the majority to take their grievances into consideration and not take final decisions without putting the minority views on board.
Opinions on such special rights being granted differ radically. Some experts argue that the Act provides for the framing of its own Articles, and since these rights are associated with the management of the company, there should be no bar to have such rights incorporated in the Articles. Others contend that these special rights are in conflict with certain provisions of the Act such as Section 6 (act to override memorandum, articles, etc.), Section 103 (quorum for meetings) and Section 47 (voting rights). Since the edifice of the Act is creation of a culture of shareholder democracy, the majority shareholders will always be in an advantageous position. However, special rights in the Articles provide a legally permissible bargaining chip to minority shareholders which can go a long way in instilling democratic ethos in the administration of the company in the true sense of the phrase.