It amazing how the seemingly easiest legal questions are sometimes the hardest to answer. Other than a 100 per cent buy out, every M&A transaction generates a shareholders’ agreement by which company owners bind themselves to special rights and obligations. How far these agreements are enforceable in Indian law is the question I seem to answer most often at the commencement of every other M&A transaction.
It’s a fair question: after all, the relationships between co-owners will most likely be the single most dominant factor influencing the future of the corporate entity. To understand this issue, let us first examine what a shareholders’ agreement typically does.
In Indian law, every shareholder is at complete liberty to exercise his shareholder’s ‘power’ as he sees fit; he has absolutely no obligation to protect the ‘interest of the company’, however that exotic gobbledegook is defined. This means that if it serves a shareholder’s purpose, he can take the company down to push his own agenda; brinkmanship in shareholder disputes being a very good example. Given this legal reality, how then is one to protect value in the company? The answer is a shareholders agreement that sets out the limits within which shareholders may exercise their shareholders rights.
In practical terms, every shareholders contract provides the manner in which a company is run, and this includes (1) the constitution of the board (2) quorums of board meetings (3) decisions the board may not take without the consent of all partners (4) quorums of shareholders meetings (5) decisions a shareholders’ meeting may not take without consent of all partners (6) solutions if the board or the shareholders are deadlocked, and (7) a mechanism by which partner disputes may be resolved without eroding company value.
In Indian law, such an agreement does not sufficiently protect value in a company. Courts here have ruled that while partners in a company may be bound to each other because they have a signed a shareholders’ agreement, the company certainly is not. This means that the company, ‘steered’ by the controlling group of partners, can ignore the contract and proceed at its will. What a shareholder contracts then gets you is litigation between partners, but it does not stop the company from doing what it wishes. This means that in practice, shareholders’ agreement or no shareholders’ agreement, the majority shareholders can bulldoze the minority
One common solution to this problem has traditionally been to make the company a signatory to the shareholders agreement. This works in many jurisdictions but again, not in India and for two reasons.
First, any party is free to violate a contract if it is ready to pay the price in damages as a court may some day determine (in this lifetime or the next!). There are any number of circumstances where a company may find it commercially wise to breach its contractual obligations and meet a greater agenda. Money does not always compensate a wrong, especially money that does not show up in this lifetime.
Second, the Rolta judgment (of the Bombay High Court) has added another twist to this issue by in effect holding that directors have a fiduciary duty to a company, not the agreement of the owners. This is a case where, by a truncated shareholders’ agreement to which Rolta Motors was a party, owners of Rolta Motors had agreed that for so long as the plaintiff had shares in the company, the board of the company would be limited to three directors. Subsequently, Rolta Motor sought to induct an additional director on to its board. On reviewing previous case law, the Bombay High Court held that directors drew both their rights and their duties from the law and the articles of the company alone. Consequently, a shareholders’ agreement could not be used to restrict the discharge of their fiduciary duty to the company.
This whole business of fiduciary duty to company versus harsh the reality of being appointees of the owners has been the bugbear of directors since companies were first conceived and 200 years of legal pronouncements have not sorted this out. That apart, I can make some sense of this pronouncement in the context of a widely held listed company, but how we are to draw a distinction between a company and its shareholders in operational matters when the company has only two owners is frankly too exotic for my nightmares-on-mean-street paradigm. Rolta did make one exception though. It indicated that the court’s decision may well have been different if the shareholders’ agreement had been written into the articles of association of the company.
Many M&A lawyers have long taken the view that we need to write shareholders’ agreements into the articles of the company, but own my reasons — for making this recommendation — are not Rolta’s. In my experience, a court will stop a decision that violates the articles of a company but a decision that breaches a contract but is not ultra vires (beyond the powers of) the company is harder to stop, though the aggrieved party could probably sue and collect some damages if and when the litigation cows finally comes home. Rolta has provided additional justification for doing this, because now, by writing shareholders contracts into articles, we are going to cast a fiduciary duty on the directors to see that this agreement is honored. That gives us lawyers several more people to drag to court and sue in their personal capacity. However, since this is the law after all that we are talking about (need we remind ourselves), this too is not the end of the matter.
Section 9 of the Companies Act states that its provisions shall override the articles of a company, its resolutions and the resolutions of its directors. It also says that to the extent that the articles are ‘repugnant’ to the Act, the articles will be void. So what is ‘repugnancy’? If the Act says it takes two directors to constitute a quorum of a board meeting but the articles say one director can constitute a quorum, are the articles repugnant to the quorum? The courts have held that this is a repugnancy. What if the articles say you need three directors to constitute a valid quorum of a board meeting? Is that a repugnancy? The courts have held that it is not. The principle seems to be that additional conditions or more stringent norms are legal but slackening of the Act is not. In simple terms, more is okay, less is not. Since three directors is more restrictive than two, the articles are legal.
Now, all this is easily understood in the context of simple numbers but what about something a little more obtuse. How about information rights? The Companies Act both enforces and limits the information directors can demand from a company. What if a shareholders’ agreement gives expanded information rights to directors? Is that more or less? I am sure I have no idea.
Take another example. Are veto rights to directors to simply overrule the majority on a resolution legal? Put this way, may be not, but we need not say it this way. We can say: “the affirmative vote of a director of each party shall be necessary for a board to validly pass a resolution.” It sounds better and can be passed of as a more stringent condition, but shorn of the rhetoric, what is it if it is not a veto? Since the law requires board resolutions to be carried by a simple majority, is this sort of provision more or less?
In truth, Indian courts have never definitively answered these questions. All we can do then is console ourselves by saying that in a dynamic world where even settled principles of law get unsettled as times, tides and people change, it may not be worthwhile worrying too much about the legal questions that have not been settled. By which token, for the moment, if an investor in an Indian company gets all the shareholders and the company to sign a shareholders’ agreement, and then gets it written into the articles of association of the company, I think the investor should be doing alright.