The Enforceability of Investor Rights in Indian Private Equity

[Arjya B. Majumdar is an Associate Professor at Jindal Global Law School]

Globally, private equity (PE) and venture capital funds are among the primary factors supporting entrepreneurship and furthering growth in companies. These investments are ordinarily made in exchange against some form of minority shareholding in the investee company, such as equity shares or convertible preference shares or debentures. While these give investors a share in company’s returns, the risks of being a minority shareholder necessitates associated and negotiated investor control and exit rights as part of the bargain.

Under a privately negotiated Shareholder’s Agreement (SHA), the investor seeks to secure some participation in the governance of the investee company in the form of board nomination rights – allowing the investor to appoint directors, quorum requirements for the presence of an investor representative at board and shareholder meetings and veto powers on certain reserved matters. The SHA also typically includes a safety net for contingencies comprising anti-dilution rights, a lock-in of promoter shares, pre-emptive rights in future fundraising, and preferential treatment in the event of liquidation. Thus, these contractual rights essentially keep promoter opportunism in check, ensure that funds invested are utilised towards the agreed  business plan and secure the investor.

However, as significant as PE funds are for corporate growth, this nuanced arrangement attracts apprehension on the enforceability of these rights, for which several factors are to blame. Corporate contracts are governed by company law as well as contract law. However, these investor control rights are a departure from company law. Further, exorbitant delays in Indian courts disincentivises parties to resolve any contractual disputes through the Indian judicial system. Instead, such disputes are generally handled by private arbitration or an out-of-court settlement. In a recent paper titled “The (Un?)Enforceability of Investor Rights in Indian Private Equity”, I explore the enforceability of these investor rights through a detailed analysis of extant company and securities law and the myriad cases that made it through the judicial system.

As discussed previously on this Blog, while deciding on the conflicts between the SHA and the articles of association of the investee company or other company legislation, the Supreme Court tends to restrict the absolute freedom of parties to contract. Even if in line with company law, it is well settled that the provisions of the SHA are enforceable only if incorporated in the articles of the investee company, irrespective of an interpretative clause in the articles that provides for the SHA to override the articles. This is further elaborated in substantial case law as well as section 6 of the Indian Companies Act, 2013, which provides that in case of conflict, company law would always take precedence over the company’s articles[1]. However, Indian courts and the Company Law Board have allowed a few departures to ensure minimal interference in the internal matters of the company, particularly if the Companies Act is silent on the issue in dispute.

Disregarding the share qualification of directors appointed to the board by certain shareholders,[2] higher quorum requirements than those required by the company laws,[3] affirmative voting rights concerning matters of the board or altering the articles are a few instances where courts have upheld the enforceability of the articles. However, it is unclear as to the enforceability of other veto rights. It is also uncertain whether the mandatory presence of a specific representative at a board and shareholder meeting for it to be quorate is enforceable or otherwise.

Where the investor has sought more stringent information rights than otherwise mandated by the company law, courts may uphold them.[4] A conjoint reading of case law and the company law suggests that the transferability of shares may be restricted and related provisions must be listed in the articles of a privately held company.[5] If complete restrictions such as a promoter lock-in are allowed, it may be safe to assume the extension of this norm to partial restrictions like the right of first offer (ROFO) or right of first refusal (ROFR) and call options as well.

In the matter of exit rights, relevant law provides for a put option in the SHA, but does not allow pre-determined pricing. However, exiting by the way of an initial public offering (IPO), specifically in connection with the investor’s right of a qualified IPO, may be unenforceable due to non-classification of an investor as a ‘promoter’ and the investor’s participation in the pricing of the IPO. The right of investors to be preferred over other stakeholders in the event of liquidation of the investee company seems another right unlikely to be enforceable owing to the well-settled law of insolvency on the subject matter.[6] However, a provision privately ranking investors higher than other shareholders holding the same class of share may be enforceable.

A general overview of case law would show that courts uphold the observance of general corporate law and norms while deciding on company law matters. Since this basic standard is favoured, there seems little reason for courts to shy away from enforcing a stricter standard in most cases concerning the SHA. As a result, practitioners who draft these SHAs ought to consider the enforceability of these investor rights when transplanting from other far more well-developed PE markets which, consequently, may be an absolute misfit under Indian law.

– Arjya B. Majumdar

[1] See ICICI Bank Ltd. v. Sidco Leathers Ltd. and Ors., (2006) 10 SCC 452; Darius Rutton Kavasmaneck v. Gharda Chemicals Limited, (2015) 14 SCC 277.

[2] Mrs. Aruna Suresh Mehra v. Jifcon Tools Pvt. Ltd. and Ors., MANU/CL/0042/1998 (CLB).

[3] Companies Act, 2013, section 103 and Companies Act, 1956, section 174; See also In Re: Subhiksha Trading Services Limited and Ors. [2011] 161 Comp Cas 454 (Mad) (holding that an increased quorum is not violative of section 9 of the Companies Act, 1956)

[4] Kapil N. Mehta, Surat v. Shree Laxmi Motors Limited, (2001) 103 Comp Cas 498 (Guj).

[5] Messer Holdings Limited v. Shyam Madanmohan Ruia & Others, (2010) 159 Comp Cas 29 (Bom.) read with Companies Act, 2013, section 58.

[6] The Insolvency and Bankruptcy Code, 2016, section 53.