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  • Baibhabi Tripathy

Winning Entry: Freeze-Out Mergers in Indian Corporate Law

[The following post has been authored by Baibhabi Tripathy, student at Symbiosis Law School, Pune, and the second winner in the IRCCL Blog Writing Competition 2022-23.]


The benefits that controlling stakeholders bring to their companies have been the subject of much debate, as have the risks that minority shareholders face when their company is run by a controller who may be motivated more by personal gain than by the company's success. Freeze-outs occur when the controlling shareholder engages in a transaction to forcibly buy the remaining shares of the company held by the minority shareholders. For situations where general agreement among stakeholders is not possible, business structures like 'majority-owned and controlled corporations' have emerged as a workaround. This notion, which has its origins in the precedent-setting case of Foss v. Harbottle, is grounded in the central premise of corporate democracy, which holds that it is up to the will of the majority to decide what is in the best interest of the company.


In India, freeze out regulation is a novel concept, but due to its significance, it is attracting a great deal of attention. Given that most businesses in India are managed, the potential of more freeze outs is extremely high. Despite this and the growing number of reform proposals, there has not yet been a comprehensive and systematic evaluation of the current law and potential reform measures in the rather distinctive institutional and corporate setting of India. This study analyses the regulatory experience of other major jurisdictions and proposes a new set of regulatory freeze out measures for India to consider.


Understanding the Notion of Freeze-Outs


The phrase 'freeze-out' often refers to the forced acquisition of the minority's equity shares for a 'fair' price set in line with the terms of the Companies Act 2013 and the Companies (Compromises, Arrangements, and Amalgamations) Rules 2016. Regardless of their form, freeze outs raise concerns for corporate law because the controller can determine the timing and price of the freeze out, even against the wishes of the minorities, because in most jurisdictions, approving a freeze out only requires a majority vote in its favour, which a controller can typically obtain. This increases the likelihood that the controller will engage in exploitative conduct towards the minority groups.


Present Laws Regulating Freeze-Outs in India


Section 395 of the Companies Act 1956 established a restricted procedure for a minority freeze-out for a transferee firm, based on the goals of the act. This mechanism is activated when at least 90% of the shareholders of the firm whose shares are being purchased approve a scheme or contract involving the transfer of shares between two companies. In such situations, the transferee business has the ability to eliminate minority shareholders.


In the same vein as Section 395 of the Companies Act 1956, Section 235 of the Companies Act 2013 permits a corporation to acquire shares from dissident shareholders using a scheme or contract that has been accepted by the majority of shareholders. This provision is patterned after Section 395 of the Companies Act 1956. It is important to note that under Sections 235(2) and 235(3) of the Companies Act 2013, minority owners who disagree with the compulsory acquisition of their shares can file an objection with the NCLT. An attempt was made in AIG (Mauritius) LLC v. Tata Tele Ventures to interpret Section 395 of the Companies Act 1956, a provision identical to Section 235 of the Companies Act 2013, in a way that maintains the principle of shareholder democracy in India. It was noted that the interests of the dissentients and the offeror must be materially different to the majority in order for the majority's vote to be validly overridden, and this is consistent with the Section's logic.


Alongside Section 235, a second new provision, Section 236, addressing the 'purchase of minority shareholding', has been added to the Companies Act 2013. For a majority shareholder or shareholders to use Section 236, the NCLAT decided that one of the events enumerated in Section 236(1) must have occurred. This means that the majority shareholder must own or acquire at least 90% of the company's shares 'through virtue of a merger, share exchange, conversion of securities, or for any other cause'. In light of this precedent, it was determined that 'for any other reason' should be interpreted ejusdem generis with the preceding phrases and would only include events that are comparable to a merger, share exchange, or conversion of securities.


In addition to the restricted mechanism permitted by Section 235, corporations have employed mechanisms such as selective capital reduction (in conformity with Section 66 of the Companies Act 2013) for minority freeze-outs. Further, in accordance with the SEBI (Delisting of Equity Shares) Regulation 2021, listed companies have the option of delisting their equity shares.


Separately, in India, freeze-outs are governed by the Companies (Compromises, Arrangements, and Amalgamations) Amendment Rules 2020 and Sections 230(11) and (12) of the Companies Act 2013, both of which were recently notified by the Ministry of Corporate Affairs.


Guarding the Interests of Minority Shareholders


Minority freeze-outs are essentially a means to seize the property of lawful minority stockholders. Expropriation of private property is widely seen as having been made more acceptable by the fact that freeze-outs can be used as evidence in court. As per the principle of proprietary interest, which states that all shareholders have a proprietary interest in the corporation and must be protected against attempts to prevent their peaceful enjoyment of property, freeze-outs may be seen as a violation of this principle.


This can have a number of effects on the minority shareholders, including the following:


  1. The minority shareholders are less likely to become minority shareholders of any company because they do not trust the management and are afraid of being frozen out of the company without their profits.

  2. The minority shareholder would refrain from investing since they do not perceive an adequate security against this freeze-out, as it just requires majority votes.

  3. The minority would perceive the discounts when purchasing specific shares as an indication that they will eventually be shut out of the enterprise; as a result, their confidence wanes.

  4. This conduct on the part of minority shareholders would reduce the company's capital and make it exceedingly challenging to obtain cash.

Typically, the performance of a corporation is evaluated simply from an economic standpoint. Maximizing profits is a desirable objective, but it cannot be accomplished in violation of some laws. Therefore, the maximization of profits cannot be used as an argument against the rights of minority shareholders. Thus, the principal function of a regulation that governs minority freeze-outs is to deal with and maintain a balance between the majority and minority shareholders' interests.


Regulatory Framework of Other Comparable Jurisdictions


Due to the fact that minority shareholders are not effectively safeguarded during freeze outs, an investigation in the regulatory frameworks of other jurisdictions to acquire insight into how this issue could be addressed is pertinent.


United Kingdom


The Companies Act of 2006 in the United Kingdom permits the acquirer to 'freeze out' minority shareholders by means broadly comparable to those used in India, including forced acquisition, strategy, and capital reduction. While the borders and processes of Indian and English laws are comparable, the legal interpretation and the minority shareholder rights are distinct. Freeze outs that are implemented in a way that harms the interests of minorities have been deemed invalid by English courts.


United States


In the United States, opportunism on the part of managers toward shareholders is one of the most prevalent types of corporate behavior found in relation to agency issues. Due to challenges with agency and the prevalence of family-owned company conglomerates in India, it is interesting to study minority shareholder protection in nations with comparable corporate ownership structures and difficulties with concentrated shareholding to India's.


Australia


Another illuminating example comes from Australia, where minority shareholders can lawfully oppose a majority vote at a general meeting if they believe it constitutes 'fraud' against them. In India, where a 'majority of the minority' vote is sufficient to pass a capital reduction bill, even if those voters harbor prejudices against the interests of a minority, this could be a useful instrument. The takeover mechanism established by Australia's Corporations Act 2001 prioritizes fairness, equality of opportunity, and protection of minority shareholders more than economic efficiency.


Singapore


Regarding freeze outs, Singapore follows the United Kingdom's example. The three methods available to freeze out the target are: compulsory acquisition by acceptance of at least 90% of the shares for which an offer has been made, scheme of arrangement, and capital reduction. In addition, Singaporean regulators have opted for compulsory purchase or scheme of arrangement rather than capital reduction.


In conclusion, we find that minority shareholders of businesses outside India are afforded protections in freeze out transactions that are unavailable in India. No suitable regulatory or judicial checks and balances have been implemented to avoid the devaluing of disadvantaged groups or the abuse of concentrated authority.


Possible Amendments


Minority protection in freeze out deals in India appears to be relatively lax. Thus, it appears that reforming freeze out regulations is an effective means of enhancing minority protection.


MoM votes


Numerous countries appear to give freeze outs more deference if they are supported by a majority of the minority (MoM) vote. While India is gradually implementing MoM for related-party transactions, its applicability to freeze outs is currently restricted. Nevertheless, even if MoM votes were mandated by law, the question remains as to whether such a rule would be helpful in defending minorities. Some larger minorities may not vote in the same direction as other minorities. Yet additional worry with MoM voting is inherent coercion - the perception stated in some US cases that minorities may vote in favour of transactions (which harm them) out of fear that the controller would find other (more harmful) ways to take value from the company if they do not.


SEBI as a regulating body


Another conceivable reform would be to give SEBI more control over freeze outs. Both the MoM plan and the fiduciary action approach require smaller minorities to take action, which can be difficult given their size. Increasing the authority of SEBI mitigates some of the deficiencies of these two systems, which both require smaller minorities to take action. It may be advantageous to have the regulator serve as an additional layer of defense.


Examination by an entirely independent board of directors


In some jurisdictions, the approval of a freeze out rests more heavily on the shoulders of an independent special committee of directors than on those of the entire board. Although the use of special independent committees for conflicted transactions (such as freeze outs) has not been widespread in India, this is likely to change in the near future as a result of the increased emphasis in the Companies Act 2013 on board independence and SEBI's efforts to increase the reliance on independent directors. Although this has not occurred in the past, it is likely to occur in the future. Freeze outs, which position controllers in direct conflict with minorities, cannot have a greater influence than they do. This is because independent directors on Indian business boards are willing to assume expanded duties and responsibilities.


Conclusion


Freeze out is an example of a sort of controller transaction that has the potential to be destructive to minority groups. An analysis of the legislation governing minority freeze-out and takeovers in different nations reveals that the level of protection afforded to minority shareholders in India is insufficient. It would be imprudent to rely exclusively on India's courts to safeguard minority shareholders during freeze-outs, as these courts have a history of favouring the company's promoters. This prejudice takes the shape of a general refusal to intervene in the internal affairs of a firm, with a few exceptions, so long as the majority supports the resolutions.


Other protections that are derived from international best practices, such as granting minority shareholders the ability to challenge a resolution in a general meeting if it constitutes a fraud on them; requiring a 'majority of the minority' vote to effect a freeze-out; or giving SEBI greater powers of investigation and adjudication to regulate freeze-outs, since it has greater financial and commercial expertise than regular courts, are all things that need to be implemented. The major concern is deciding which solutions to pursue in light of the realities on the ground and the institutional constraints in India.


In the context of Indian culture, a combination of more regulatory oversight and voting rights or other safeguards is perhaps the most ideal approach. There are a number of modifications that could be considered to better the balance between the protection of minority and the encouragement of value-enhancing freeze outs; however, these modifications are still pending for future work.

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