Testing the Validity of a Type of Shareholders’ Agreements in India

[Priya Garg is a 4th year student at the West Bengal National University of Juridical Sciences (WBNUJS)] 

In the Indian context, shareholders’ agreements (SHAs) have been widely categorized into two types – one, that impose restrictions on the transferability of shares held by the shareholders who happen to be the parties to the SHA (type 1 SHA) and the other, which deal with the matters relating to company’s internal governance (type 2 SHA). For instance if, in an SHA, the parties (who are also the shareholders of a company) decide that one of them would have a right of first refusal (ROFR) if the other party wishes to sell its shares in the company to any third party, it is a type 1 SHA. It imposes restrictions on transferability of shares of the person against whom ROFR can be enforced. However, if an SHA contains a clause stating that a particular party would have veto rights, it is an illustration of a type 2 SHA. This is because possession of veto rights is a matter pertaining to internal governance of a company.  

The discussions regarding the validity of SHAs in India have hitherto remained centred around analysing the legality of the type 1 SHA. A fair level of deliberations is yet to occur regarding the validity of type 2 SHA in India. The present post seeks to fill this void. This issue however has been discussed only against the backdrop of the instances wherein SHA has not been incorporated into the company’s articles of association (AoA).

In a catena of cases,[1] the issue of the legality of type 1 SHA has been discussed. Except the case of VB Rangaraj v. V.B. Gopalakrishnan (‘Rangaraj’), all other cases have considered the issue of the enforceability of type 1 SHA by solely debating (a) what constitutes the restriction on the transferability of shares and (b) if imposition of such a restriction has been allowed under the Companies Act, 2013 (or the prior legislation of 1956) and, if yes, what is the extent of such permissibility. These cases however have discussed these two issues against the backdrop of the position laid down in Rangaraj that any provision in an SHA which contravenes the AoA or the Companies Act is void. Therefore, the reasoning employed in these cases other than Rangaraj regarding the validity of type 1 SHA would be inapplicable in deciding the legality of type 2 SHA in India. This is because the hurdle that exists against the validity or enforceability of each of the two types of SHAs is different. I elaborate on this point subsequently in this post.

Hence, only four cases become relevant to decide upon the legality of type 2 SHA namely, Rangaraj, IL&FS Trust Co. Ltd. v. Birla Perucchini Ltd. (‘IL&FS Trust’), Vodafone v. Union of India (‘Vodafone’) and World Phone India Pvt. Ltd. v. WPI Group Inc ( ‘World Phone’).[2]

The Rangaraj case involved a private company. The parties to type 1 SHA imposed restrictions on the transferability of their shares by including an ROFR clause. This clause was not incorporated into the company’s AoA. Subsequently, an issue arose regarding the validity of such an agreement. In that case, the Court highlighted the importance of a company’s AoA and memorandum of association (MoA). Thereafter, it emphasised that as per the combined reading of sections 3(iii) and 82 of the Companies Act, 1956, in case of a private company, restrictions on transferability can exist only if specified in the company’s AoA. Since, in this case, the AoA had already prescribed the restrictions on share transferability, therefore the additional restraint imposed under the SHA was considered to be ‘contrary’ to the Companies Act and the company’s AoA. Resultantly, the type 1 SHA was adjudicated as being unenforceable.

The utility of Rangaraj in adjudging the validity of type 2 SHA is, however, limited. This is because, as has been explained above, the irregularity that an SHA begins faces by its non-incorporation in company’s AoA is unique to a type 1 SHA. By virtue of the combined reading of provisions such as sections 3(iii) and 82, it emanates that if a restriction on share transferability is incorporated in the SHA which is not made a part of the company’s AOA, then the restriction goes against the Act as well as the AOA. This may not be the case always in case of Type 2 SHA even it is left unincorporated.

The Rangaraj case can be directly applied to declare a type 2 SHA as invalid due to its non-incorporation in AoA only when the SHA has a clause on the matter regarding which the Companies Act has explicitly required that modifications on that matter can be made only through a clause under an AOA (as is the case with the conditions relating to transferability of shares).

However, this argument that I just advanced regarding the limited scope of application of Rangaraj was also raised by the petitioner’s counsel in the subsequent case of IL&FS Trust. In IL&FS Trust, a public company was involved. Both the shareholders and the company were parties to a type 2 SHA. Under it, the promoters agreed that the other party to the SHA shall not resign from the board till the SHA remained operative. This clause was not incorporated in the company’s AoA. Later, the second respondent resigned, thereby breaching the SHA. An issue arose regarding the validity of such a clause which is outside the AoA.

Amidst these circumstances, the petitioner’s counsel suggested that the Rangaraj ratio would be inapplicable to the case at hand because the former case dealt with the legality of type 1 SHA and its reasoning would be limited to that only. The Court rejected this argument. It read Rangaraj to have stated that “a restriction which is not specified in the articles of association is not binding either on the company or on the shareholders”. This was where it committed a fallacy. It would have been correct for the court in IL&FS Trust to extend the verdict of Rangaraj even to cases involving the issue of the legality of type 2 SHA had Rangaraj ‘actually’ stated such a ‘broad’ proposition. However, Rangaraj only pronounced that (a) since the Companies Act requires that the shares remain a freely movable property unless any restrictions on share transfer has been stated in an AoA and (b) since the company’s AoA already had provisions prescribing the restrictions on share transfer, the SHA mentioning additional restrictions on share transfer went ‘contrary’ to the Act and the company’s AoA. Hence it was void. Therefore, in Rangaraj, the SHA clause was not declared as invalid on the mere ground of its ‘non-incorporation’ in the AoA.

Since the position laid down in IL&FS Trust is based on a fallacious reading the precedent, it remained prone to be whittled down. This is exactly what Vodafone did. The Vodafone case became the first to appreciate the multi-faceted and the truly complex nature of an SHA. This is because it acknowledged that the SHA as a document is situated at the confluence of contract and corporate law. The SHA is ultimately an ordinary contract. It is only that its legality is a matter of debate under corporate law as well because its subject matter revolves around the manner in which the company’s affairs will be conducted and the rights and liabilities of the shareholders and the company. Since the SHA is governed by two legal regimes, its mere non-enforceability (as opposed to ‘illegality’) under corporate law does not ipso facto imply its non-enforceability under contract law as well. This is because under Contract Act, 1872, an agreement becomes invalid if it falls under section 23, i.e. if it is forbidden by law or is of such nature that, if permitted, would defeat the provisions of law. Since corporate law is an enabling (and not a penal) statute, an SHA is not ‘forbidden’ by company law. Further, it is not always that enforcing an SHA under contract law would defeat the provisions under company law. Sometimes company law itself allows for such contracting explicitly or impliedly or through its silence on certain aspects which an SHA deals with. Hence, where an SHA is not affected by section 23 of the Contract Act, it could be enforced as an agreement under contract law even when no remedy can be awarded for its breach under corporate law.

However, doubts can be raised regarding the binding nature of this stance adopted by Vodafone as it is obiter dicta and hence cannot legally overrule the position laid down in Rangaraj (a two judge bench decision). Nevertheless, that is not an issue because Vodafone, despite disagreeing with Rangaraj, did not overrule it. This is because Vodafone itself also misread Rangaraj in the same manner as the court in IL&FS Trust did. Hence, it is possible for the observation in Vodafone and the ratio of Rangaraj in its true sense to co-exist.

Hence, given (a) the limited scope of the application of Rangaraj and (b) the fallacious reasoning in IL&FS Trust, the position laid down by Vodafone reflects the true and the latest position of law regarding the legality of type 2 SHA.

However, suspicion may continue to exist regarding the impact that Vodafone has actually created (or could potentially create) in this matter because the subsequent High Court case of World Phone did not mention or follow Vodafone. Instead it prima facie appeared to have gone even a step beyond Rangaraj by stating that an SHA clause which has not been incorporated in company’s AoA, even when it does not go ‘repugnant’ to the Act, is unenforceable. This stance is considered to be a step ahead of Rangaraj because Rangaraj only pronounced that in case of ‘repugnancy’ with the company’s AoA and the Companies Act, the SHA becomes invalid and not otherwise.

However, this kind of understanding regarding the World Phone is arguably incorrect. In the case, affirmative voting rights were conferred under the SHA regarding certain matters in favour of one of the members. However, the decisions were taken in the company’s meeting without honouring the SHA clause. Hence, the Company Law Board (CLB) was requested to declare these decisions as invalid. The CLB accepted this demand. While exercising its appellate jurisdiction, however, the Delhi High Court reversed the CLB’s position. The Court held that the SHA not incorporated in the company’s AoA is non-binding on the company even when the SHA does not run repugnant to the Act (implied application of the doctrine of privity that exists under contract law).

This is exactly where a careful reading of the verdict is needed. When the Court said that the SHA was not binding, it did not state that it was invalid or absolutely non-enforceable. Instead, it specifically stated that it was not binding ‘on the company’. This was because the company was not a party to the SHA; and for the decision, which has already been taken at the company’s meeting, to be reversed the company needed to be a party to the SHA. Hence, the per se legality of type 2 SHA was not even an issue in World Phone. In World Phone, the Court’s citing of Rangaraj and IL&FS Trust was for the limited purposes to conclude that the SHA which has not been imbibed in an AoA cannot bind the company. Therefore, it would be incorrect to state that World Phone reaffirmed Rangaraj in a manner that would practically render Vodafone ineffective.

Therefore, overall, it can be inferred that regarding the validity of type 2 SHA, Vodafone is the only direct and legally as well as logically sound position on the matter. However, since the observation is argued to be merely an obiter, it holds only a persuasive value. Therefore, there is no binding case which is an accurate position of law on this issue in the Indian context.

– Priya Garg

[1]Mafatlal Industries Ltd. v. Gujarat Gas Co. Ltd., MANU/GJ/0012/1997; Smt. Pushpa Katoch v. Manu Maharani Hotels Ltd., MANU/DE/0867/2005; Western Maharashtra Development Corpn. Ltd. v. Bajaj Auto Limited, MANU/MH/0109/2010; Messer Holdings Limited v. Shyam Madanmohan Ruia, MANU/MH/0998/2010.

[2]The last three verdicts directly deal with the legality of type 2 SHA. Rangaraj is relevant as its legal position, that an SHA provision contravening the AoA or the Act is neither binding on the shareholders nor on the company, is useful for discussing the legality of type 2 SHA.