Thursday, June 6, 2013

Conflicts between Shareholders Agreements and Articles of a Company


[The following post is contributed by Aditya Swarup, who is an advocate practising in the Bombay High Court. He has a B.A., LL.B (Hons.) degree from NALSAR, Hyderabad and B.C.L. and M.Phil degrees from Oxford]
The issue of conflicting provisions in a Shareholders Agreement (SHA) and the articles of association (Articles) of a company is a never ending debate, and perhaps a rather confounding one in company law. A recent order of the Delhi High Court in World Phone India Pvt. Ltd v. WPI Group Inc USA, [2013] 178 Comp Cas 173 (Del) (also available here), holding that clauses in a SHA which are not repugnant to the Companies Act but not incorporated in the articles of the Company, would be unenforceable, has only added to this confusion. This post is an attempt to expound the law surrounding this decision.
As a background, it would be apt to note that conflicts between SHA and the Articles of a company can be of two types; first, where the conflict relates to the management of the company (affirmative vote, board of directors, accounts, etc.) and second, where the conflict relates to the transferability of shares. The latter has been the subject of extensive case law in the Supreme Court and High Court and has been dealt with in this blog at various instances (e.g. here and here).  As regards the former, two main questions arise;
1)           Whether a provision in a SHA that is contrary to the Articles of the company is valid and enforceable?
2)           What are the possible remedies for a shareholder against breach of a SHA by other shareholders even though such action would not be construed as a breach under the Articles of the company?
Probably the most important case in this regard is that of VB Rangaraj v. VB Gopalakrishnan, (1992) 1 SCC 160 (available here). In that case, while dealing with a conflict between the SHA and the Articles of the company of the latter type, i.e. a conflict dealing with the transferability of shares, the Supreme Court took the view that the provisions of a SHA imposing restrictions even when consistent with the Companies Act, are to be authorised only when they are incorporated in the Articles of the Company.  The decision of the Supreme Court was based on the seemingly settled position that where there is a contradiction between the SHA and the Articles of acompany, the latter will prevail. In IL & FS Trust Co. Ltd. v. Birla Perucchini Ltd., [2004] 121 Comp Cas 335 (available here), the decision in Rangaraj was also held applicable to conflicts in the Articles and SHA not involving transfer of shares.
It is settled law that the Articles of a company would prevail when there is a contradiction between the SHA and the Articles. But assuming that there is a certain provision in the SHA that has not been incorporated in the articles of the Company, would it mean that merely because the articles are silent (not contradictory), the articles will prevail?
The answer to this question might lie in recognition of the legal position that a company is controlled only by its Memorandum and Articles. The Articles are a form of a statutory contract binding all the members of the company as regards the affairs of the company. A company cannot contract outside the Articles in so far as the management of the affairs of the Company is concerned, and any other agreement attempting to bind the company as regards its affairs, not provided for in the Articles and Memorandum of the company, may not be enforceable. For instance, a provision in a SHA giving a casting vote to the Chairman of the Board in case of a tie, not provided in the Articles, will not be enforceable. However, this may also depend on whether the company is a party to the SHA. (See Russell v. Northern Bank Development Corp Ltd, [1992] 1 WLR 588 )
 In World Phone, the Board of Directors of the company passed a resolution approving a rights issue in accordance with the Articles of the company, even though such an action required the affirmative vote of the Appellant in accordance with a SHA entered into between the shareholders of the company. The Company Law Board had held that since the provisions of the SHA granting an affirmative vote to the appellant were not incorporated in the Articles of the company, the said provision is unenforceable and the board resolution approving the rights issue was valid. On appeal, Justice Muralidhar of the Delhi High court held;
“ the legal position is that wherethe articles of association are silent on the existence of an affirmative vote, it will not be possible to hold that a clause in an agreement between shareholders would be binding without being incorporated in the articles of association. The question to be asked is whether the provisions of an agreement, that are not inconsistent with the Act, but are also not part of the articles of association, can be said to be applicable. All that section 9 states is that the clauses in the agreement that that “repugnant” to the Act shall be “void”. This does not mean that the clauses in the agreement which are not repugnant to the Act would be enforceable, notwithstanding that they are not incorporated in the articles of association.”
Thus, the court has held that the provisions of the SHA, though silent in the Articles of the company, and not in contradiction with them, will not be enforceable.  This ruling, as it stands, brings in a lot of confusion to the issue of conflicts between SHAs and Articles of a company- because the issues don’t stand resolved merely with the conflicting provisions being unenforceable. Further issues arise in light of the judgment of the Supreme Court in Vodafone International Holdings BV v. Union of India, (2012) 6 SCC 613 (available here), that have not been considered by the Delhi High Court in World Phone.
 In Vodafone, three main observations were made by the Supreme Court on the issue;
a)         That the Supreme Court does not subscribe to the view in Rangaraj that restrictions in a SHA, though consistent with company law, are to be authorised only when they are incorporated in the articles of the Company. (it is still doubtful whether Rangaraj has been overruled as the Court didn’t explicitly say so)
b)         Shareholders can enter into any arrangement in the best interests of the Company, but the only thing is that the provisions of SHA shall not go contrary to the articles of the Company.
c)         Breach ofSHA which does not breach the Articles of a company is a valid corporate action, but the parties agreed can get remedies under the general of the land for breach of any agreement and not under Companies Act.
In light of the above, a logical extension of the judgment in World Phone would be that even though the provisions of an affirmative vote are not incorporated in the Articles of the company, and though the action of the company in providing for a rights issue would be valid under the Companies Act, such an action will still be in breach of the SHA for which the aggrieved shareholder can pursue an action for breach of contract.
This view is also consistent with the position in English law. In Southern Foundries Ltd v. Shirlaw, [1940] AC 701 it was held, “a company cannot be precluded from altering its articles thereby giving itself power to act under the provisions of the altered articles–but so to act may nonetheless be a breach of contract if it is contrary to a stipulation in the contract validly made before the alteration”, and the court awarded damages for wrongful dismissal of the managing director of the Company even though the mode of dismissing was valid under the Articles of the company.  There is considerable opinion to show that the relief may also lie in terms of an injunction to restrain it possible breach of the SHA contract.
On 9th May, 2013, the Supreme Court refused to admit a SLP in the World Phone case stating the opinion expressed in the order was only as regards interim relief and that the CLB was to decide the issue uninfluenced by the observations of the High Court. This sets the stage for a new round of litigation where it is hoped that issues concerning the conflicts between SHAs and Articles of a company would be finally settled.
- Aditya Swarup

11 comments:

vswami said...

Instantly, not one but many points of doubt arise; some are these:
1. Under the company law, one of the aspects being touched upon herein, namely, 'transferability',- to be precise any restriction on "free- transferability" of shares has a legal implication or significance of its own. In that, if there be any such restriction in the articles, then, going by one's impression (open to correction), the complexion/classification of the company itself will be different. Reference is to the definition in law of the terms "public company" and private company".
2. Do not the views need to be specially considered /reviewed depending upon say, in a case where the noted mutual conflict is with reference to any later amendment of the original articles but the SHA is one entered into before such amendment.

Incidentally,it calls for a special noting that, any such conflict between the SHA and Articles is basically of a ‘contractual’ type. And,is prima facie distinct from any conflict or non-compatibility between any two (or more)related statutes - say, the decades-old Transfer of property Act and a statute coming into force at a later point in time e.g. the state special enactment on "Apartments" (being a property clearly distinct from a wholly owned independent house property solely governed by the TP Act). Nonetheless, a study of decided court cases on the latter- mentioned type may possibly provide useful clues and guidance on the former.

Simply sharing above own spontaneous thoughts. Hoping to have made sufficiently clear, the earnest suggestion to seasoned law experts is to consider whether or not the subject matter requires a multidimensional approach for coming to proper or better conclusions.

Anonymous said...

"... This does not mean that the clauses in the agreement which are not repugnant to the Act would be unenforceable, notwithstanding that they are not incorporated in the articles of association.”
Thus, the court has held that the provisions of the SHA, though silent in the Articles of the company, and not in contradiction with them, will not be enforceable.

Isn't what is said in the judgment and the conclusion drawn by Mr. Swarup contradictory? There's a double negative in the statement.

Aditya Swarup said...

Correction - the quote in the judgment is to be read as "enforceable" and not "unenforceable"

Archana Balasubramanian said...

While I have not read the AOA of the Company, its safe to presume that the articles would contain provisions relating to board meetings, voting thereat and validity of proceedings. In light of this, the thought process in this judgment may not be very far from the mark.

It would of course be interesting to see what Supreme Court would state where an article of association is silent on the issue and no provision can be said to be repugnant thereto.

These facts may not however fall into this arena of articles being silent on the issue. if affirmative voting items are not included in the articles, the general provisions on voting at board meetings should apply.

vswami said...

On the first of the two types referred as the conflict as relates to “the management of the company (affirmative vote, board of directors, accounts, etc.)”, on the flipside, it is, in a manner of speaking, at times if not at all times, attributable to what has come to be increasingly debated in the context of shareholders’ activism. Be that as it may, here is a write-up reflecting critical views obtaining beyond the national borders, but with a different stroke. To read, look up @
WASHINGTON TIMES (WT) >
On the right, a rising passion for shareholder activism

Anonymous said...

There is an error in your facts. The CLB held the meeting held for approval of rights issue void and not valid as you state. The matter was therefore in appeal to the High Court.

Anonymous said...

Very interesting post. What are your views on the position where there are points in the shareholder's agreement specific to the relationship between the shareholders, such as "confidentiality", "non compete", general boilerplate, that are not reflected in the articles?

Anonymous said...

Hello. I am from Russia and my english is very bed,sorry. I am a student of the Ural state law academy. The title of my graduate work is "The Shareholders agreements in russian and foreign civil law". It is not easy to find information by russian language about shareholders agreements in foreign law,especially about law of India,China and other states,except the USA a the UK. If it is not difficult for anybody, please, take me useful references to websites.Previously thak you!

Anonymous said...

What about a situation where an agreement stating that a special resolution will not be passed unless the minority shareholder (25 %) votes for the resolution. It is a protection to the minority shareholder but it also defeats the provision of the companies act' with regard to the majority (75 %) required for passing up of a special resolution ?

Umakanth Varottil said...

@Anonymous. Veto rights to minority shareholders (even if they hold less than 75%) are generally said to work because they impose a majority requirement for passage of a resolution more than what the law requires. Hence, if there is a more onerous requirement over and above the legal requirement, that would be alright, but there can be no compromise to the basic legal requirement (i.e. majority less than 75% for a special resolution).

Tarun said...

I do not understand how the court can preclude the parties from pursuing a remedy under contract law for a breach of the SHA. This judgement seemingly restricts the enforceability of a provision of the SHA which has not been included in the Articles of Association purely in terms of whether such provisions are binding on the company as an entity, assuming the company was not party to the SHA.
Could it be argued however, that any remedy, even under contract law, when enforced against a shareholder is effectively enforcing it against the company in terms of affecting decisions taken by some shareholders which could potentially impact all the shareholders of the company.
For example, consider a provision in the SHA granting a shareholder a right to an affirmative vote. This is not incorporated in the Articles of Association. In the event that a decision is taken ignoring this required affirmative vote, what remedy would the party then be left with?