Shareholders' Agreement: Enforceability Issues in India

H. Jayesh, Juris Corp Advocates & Solicitors

It would be trite to state that the enforceability of any contract (which is not perceived as violative of any law) is taken for granted. This may not however, always hold good (especially in India). Enforceability of Shareholders' Agreement ("SHA") is one such instance.

This article highlights some of the issues, which are relevant and could come in the way of enforcing SHAs entered into in relation to investments made in, or a joint venture with an Indian company (the "Target Company"). This is also relevant where the investments in the Target Company are being made through an offshore vehicle or another Indian entity ("Holding Company"). Even where the SHA is governed by any system of law other than Indian law ("Foreign Governing Law"), the issues being highlighted would, in our view, be equally relevant (if not more). Whether the choice of any Foreign Governing Law itself will be upheld as valid (as the Target Company is an Indian company) is itself an issue that requires careful evaluation and the investment be accordingly structured.

In the Indian context, it would be indeed perilous not to have the Target Company (and for that matter the Holding Company, if there is one) as a party to the SHA. Failure to do so would invariably mean that even if the provisions of the SHA are to be breached, the chances of remedying or preventing the same (other than by way of obtaining damages, which in India would not be extensive) would be diminished.

The enforceability of the SHA, though otherwise constituting a valid contract between the shareholders, against the Target Company is a problem area.

The issue that arises is that if the Target Company is a party to the SHA, then is the SHA (in its entirety or substantively) enforceable against the Target Company whether or not reproduced in the Article of Association of the Target Company ("AoA"). The law, as laid down by the courts in India, is that even if the Target Company is a party to the SHA, but the provisions of the same are not reproduced in the AoA then, the courts will not direct specific performance of the SHA (as against the Target Company) or for that matter injunct the Target Company from breaching the SHA if its actions are otherwise (de hors the SHA) valid. The fact that the shareholder procuring the breach may be directed to pay damages may not be of much succour. In this context, the provisions that an investor in the Target Company ("Investor") should be concerned about would include:

  • Anti-Dilution Rights
  • Appointment (and removal) of directors including Investor nominees ("Nominee Directors")
  • Veto Rights of Nominee Directors/of Investor as a shareholder; Quorum and Conduct of Meetings (Board and Shareholders)
  • Transfer of Shares Covenants (including 'Tag Along' & 'Drag Along')
  • Exit Options
  • Liquidation Preference

The next issue to be addressed is that even if the provisions of the SHA are reproduced in the AoA (such AoA referred to as "Amended Articles"), to what extent are they enforceable. The only direct statutory provision is Section 9 of the Companies Act, 1956 (the "Act"). This stipulates that in the event of the Memorandum & Articles of Association of a company containing any provisions, which are inconsistent or contrary to the provisions of the Act, the provisions of the Act will prevail.

The question that therefore arises is what if the provisions of the Amended Articles are contrary or repugnant, not in letter but in spirit, to the provisions of the Act.

In this context:

Can the Amended Articles have provisions, which are more exacting than the Act, such as: If the Act requires certain decisions to be taken by a special resolution or an ordinary resolution or (as in many cases), where the Act is silent (as to the nature of the resolution or method of deciding), can the Amended Articles stipulate that a resolution shall be valid only if approved by/not objected to by the Investor ("Super Majority Approval"); Any shareholders' resolution shall not be valid unless: Approved by shareholders holding more than a pre-specified shareholding (say 66% / 76% / 90%), or Super Majority Approval is obtained. Any Board Resolution shall not be valid unless: Approved by a particular number of directors (more than a simple majority) or by one or more of the Nominee Directors, or Ratified by the shareholders by a Super Majority Approval (including on matters for which the Act specifies only a board resolution). To what extent can a Nominee Director veto board resolutions only because: Directed to do so by the Investor, and/or It is inimical to the Investor's interest;

though such resolution may be in the interest of the Target Company. In this context, can the Target Company claim mala fides (on part of the Investor/Nominee Director) and still proceed to act on the resolution if the same is otherwise approved by a majority of directors or in the manner required by the Act.

Can the Amended Articles provide for a circular resolution of the shareholders to be passed: Where the Act requires the shareholders to decide by passing a resolution (special or ordinary); or Where the Act does not specify the manner in which the shareholders are to decide. Can the Amended Articles provide that Investor(s) or group of pre-specified shareholders (either by name or whose combined holding exceeds a particular %) by passing a resolution compel the Target Company or other shareholders to a particular action.

Such actions could include:

Merger with another company; Allotment of shares at a particular valuation. Can the Amended Articles provide that in the event of a deadlock (whether at the board level or in a general meeting) the decision of the Investor (or Nominee Director) or of pre-specified shareholders (or directors nominated them) shall determine the same and the resolution shall be deemed to be determined accordingly.

As regards the requirements of directors having to vote in a particular manner, the following ruling of the Bombay High Court in (2000) 100 Company Cases 19, is relevant:

"It is clear thus that the specific performance of pooling agreements between the shareholders to vote in a particular manner cannot be extended to denude or sterilise the powers of directors and any such agreement would be unenforceable."

The decision of English courts in (1992) 3 161 HL, (1905) 21 TLR 464 & (1970) 1 53 HL are pointers to be kept in mind as rulings of courts in England do have persuasive value before Indian courts. The judgments of the Indian Supreme Court in (1961) 31 Company Cases 301 and (2000) 100 Company Cases 19 are also interesting. These two judgments (in a varying manner) do seem to imply (but do not actually state so) that the powers vested by the Act in the board of directors can be, subject to certain caveats, taken away or modified by the shareholders in a general meeting.

In view of the above, the next question to be addressed is to what is the approach to be adopted by an Investor so that the Amended Articles (providing for all or any of 1 to 5 above or more) can reasonably be expected by the Investor to be enforced. This, in effect, is the key issue. Alas, it is not possible to meaningfully answer the above without peppering it with 'ifs' and 'buts'. Without getting into great details (due to the constraints of this article), it would suffice to say that an in depth review of the various issues should be effected and then decisions taken as to the following: identify the provisions, which must be provided for even if their enforceability is uncertain and separately identify the provisions which may be watered down-but a greater certainty as to their enforceability. In other words, an attempt should be made to strike a via media between the commercial and legal objectives and a collaborative effort.

In addition to the above and most critically, the SHA should provide for arbitration as the means of dispute resolution. The venue should, preferably, be kept outside India and certain other provisions be also built in. As an arbitral award is almost on the same footing as a decree of a court but given that it is arbitration, the probability of the Amended Articles being enforced would be higher. Here again care must be taken that the arbitration provisions binds all concerned parties-though the right to submit to arbitration and appoint arbitrators may be vested in some parties only.

Armed with the above, an Investor should be able to mitigate most risks. Happy investing!

About The Author

Juris Corp is a boutique law firm rendering legal and advisory services in a focused manner in a select few and inter-related fields. The forming of Juris Corp, contrary to the global trend of cross border mega mergers of law firms, is a proactive step towards addressing the need for specialised legal practitioners in India. Juris Corp believes in specialisation and accordingly acts only in its chosen areas of practice.

H. Jayesh
Juris Corp
Advocates & Solicitors
1210, Maker Chambers V
Nariman Point
Mumbai 400 021