Executive summary:

The Companies Act, 2013 (“2013 Act”) was expected to simplify life for corporate India, strengthen corporate governance norms and make India an attractive and safe investment destination. Introduced with the objective of consolidating and amending the existing law applicable to companies, the 2013 Act contains 470 clauses as opposed to nearly 700 sections under the Companies Act, 1956 (“1956 Act”). The central government has been empowered to make rules under many provisions of the 2013 Act. While many of the rule making powers are procedural, certain substantive provisions have been delegated, which could have far reaching implications for corporate India. Various provisions of the 2013 Act have marked a considerable departure from the extant positions under the 1956 Act.

This article seeks to examine certain key changes with regard to shareholder rights and structuring restrictions proposed under the 2013 Act, which could impact conventional deal making methods.

Posted In: India, M&A (General), Legal Regime, Regulatory Matters

Main Article:

Veto Rights and ‘Control’

The introduction of the concept of ‘control’ in the 2013 Act[1] has implications for investors in Indian companies. Under the 2013 Act, ‘control’ is understood to include the right to: (i) appoint a majority of directors; or (ii) control the management or policy decisions exercisable by a person or persons acting individually or in concert, directly or indirectly, including by virtue of their shareholding or management rights or shareholding agreements or voting agreements, or in any other manner. The definition is similar to the definition of ‘control’ under the Securities and Exchange Board of India (Substantial Acquisition of Shares and Takeovers) Regulations, 2011[2] (“Takeover Code”). The definition of ‘control’ and the jurisprudence surrounding the same under the Takeover Code has been developed with the objective of protecting minority shareholders and providing an exit to them in the event of change in its control. The definition of ‘control’ is linked closely with the definition of ‘promoter’. The 2013 Act provides that a person having control over the affairs of the company would be regarded as its ‘promoter’.

Given the similarity in the definition of ‘control’ under the Takeover Code and the 2013 Act and its linkage to the definition of ‘promoter’ it is likely that the jurisprudence of control under the Takeover Code would be applied under the 2013 Act, as well. But, the scope of the term ‘control’ under the Takeover Code itself is not clear. While the Securities Appellate Tribunal (“SAT”) had held that affirmative voting rights granted to investors would not amount to ‘control’,[3] the Supreme Court has left the question open in the Subhkam decision[4] by ruling that the SAT’s order would not have any precedent value. The Securities Exchange Board of India (“SEBI”) has not laid down any test to determine with reasonable certainty the point at which a person acquires control. With the new definition of ‘control’ under the 2013 Act, the prevailing uncertainty around what constitutes ‘control’ would impact deal making with respect to unlisted companies as well.

The uncertainty around the interpretation of control would impact negotiation of shareholder agreements. Affirmative vote rights in favour of investors under a shareholders agreement are meant to be an effective tool for safeguarding investment or the interest of the investors. These rights are negotiated and decided in the shareholders agreement, which are subsequently incorporated into the articles of association of a target company. Accordingly, an investor or shareholder who has secured for itself certain rights which enable a degree of control over ‘management or policy decisions’, whether by way of board representation or veto rights, may be regarded as having ‘control’ of the company and therefore be classified as a ‘promoter’. Investors would need to carefully consider the obligations and liabilities associated with the position of a promoter under the 2013 Act when negotiating rights and powers in a company under the shareholders agreement.

Transfer Restrictions

Apart from veto rights, shareholder agreements also provide for certain exit rights and restrictions on transferability of shares of the company. Such rights typically vary based on the nature of the investment or the acquisition structure and range from pre-emption rights to call and put options. While transfer restrictions are enforceable in case of private companies, their enforceability in relation to shares of a public company has not been established conclusively. The 2013 Act[5] prescribes that the shares of a public company would be freely transferable but has introduced a carve-out for any contract or arrangement between two or more persons in respect of transfer of securities, which would be enforceable as a contract. This exception could be an attempt to codify the principle laid down in the decision of the Bombay High Court in the Messer Holdings case,[6] wherein it was held that an agreement between shareholders restricting the transfer of shares in a public company is not in violation of the law mandating free transferability of shares of a public company. However, the provision could have been drafted with more clarity to achieve the desired objective.

Under the 2013 Act, unless a company is not a party to the agreement containing transfer restrictions, the same would not be binding on the company and it would be free to register any transfer of shares in contravention of such restrictions. But the clause in the 2013 Act does not support the view that a public company can be bound by contract to restrict the transfer of its shares. In the absence of such a contract being enforceable against the company, an aggrieved party would only have a right to claim damages for breach of contract against the defaulting seller in cases of sale in breach of transfer restrictions. A remedy of specific performance or injunction may be available against the seller only if such sale has not been completed.

Entrenchment

Another new development in the 2013 Act is the recognition of entrenchment provisions in the articles of association of a company. The purpose of shareholder agreements is to secure certain rights for shareholders which have not otherwise been made available to them under law. For example, an investor holding 20% shares in a company may want a say in an alteration of the investee’s articles which affect its rights in the company. As the law only mandates a special resolution (3/4^th majority of shareholders present and voting) for any alteration to the articles to be approved, the consent of the investor may not be required. In such a situation, the shareholders agreement may mandate an affirmative vote of all shareholders for any such alteration to be approved. While inclusion of such rights has been the norm in most shareholders agreements, the same has been granted legal sanctity under the 2013 Act[7]. Under the 2013 Act, articles of a company may contain provisions for entrenchment such that certain specified provisions of the articles may be altered only upon the satisfaction of conditions or procedures that may be more restrictive than those applicable in the case of a special resolution.

There has been some debate on the validity of affirmative rights in favour of minority shareholders, for a company to perform certain actions. The rationale behind the debate being that such affirmative rights place a higher threshold on the company than what is statutorily prescribed under law for exercising such actions. The Punjab and Haryana High Court[8] has, in the past, ruled that a company is not prohibited from providing a higher quorum for board meetings in its articles than that prescribed under the 1956 Act. The underlying principle which may be inferred from this decision is that it is permissible for a company to adopt a higher threshold of compliance than that required under law. However, the Company Law Board’s decision in the Jindal Vijaynagar[9] case invalidated the affirmative rights of a minority shareholder from preventing a change in the location of the registered office of a company. The new provision for entrenchment does not expressly grant recognition to affirmative rights in the hands of minority shareholders in situations where the statute provides for voting thresholds. But, it at least grants legal sanction to affirmative rights on amendment of the articles of the company.

Apart from the issue of shareholder rights and their enforceability, the 2013 Act also affects, amongst other things, the manner in which investments are held or made.

Layering 

A significant development under the 2013 Act is the restriction introduced on a company from making investments through more than two layers of investment companies (i.e. companies whose principal business is the acquisition of shares, debentures and other securities).[10] There is no guidance within the 2013 Act on determination of the principal business of a company. This phrase has also been the subject of debate under the non-banking financial companies’ legal regime, governed by the Reserve Bank of India. In the absence of any statutory clarity in this regard, deal structures would need to be looked into carefully to ensure compliance with this restriction.

Private Companies: Fund Raising

As mentioned at the outset, the 2013 Act seeks to protect interests of minority shareholders and this has resulted in curbing the flexibilities available to private companies under the 1956 Act. Various provisions have been introduced across the statute, which effectively nullify the advantages of incorporating a private company over a public company. Of these, those associated with fund raising activities are of particular relevance to investment transactions.

The process of a ‘rights issue’ under the 1956 Act[11] has been made mandatory for even private companies, with certain additional requirements. A special resolution would be required for any preferential allotment of shares with the pricing being determined by a registered valuer.[12] In addition to the above, cumbersome requirements (including issuance of a private placement offer letter and filings with the registrar of companies) usually required to be followed by public companies, will have to be adhered to by private companies even in case of standalone placements which constitute an ‘offer’ or ‘invitation to offer’. However, given that most private companies are closely held, except for the added paperwork and factoring of such processes in transaction timelines, it should be possible to work around the regulatory framework to ensure uninterrupted operations.

Classes of Shares – Private Companies

Another significant change under the 2013 Act is its position on shares with differential rights. The 1956 Act permitted a private company to issue shares of various classes, each of which could have different rights in terms of dividend, voting or any other special rights. While public companies were required to meet the stipulated conditions for issuing such shares, private companies had been exempted from the same.[13] The 2013 Act provides that private companies would also have to comply with the rules, to be framed by the government in this regard, in order to be able to issue shares with differential class rights. Otherwise, the voting rights of each shareholder in a poll would have to be proportionate to such shareholder’s share in the paid up capital of company.[14] While the government is yet to release the rules for issuing shares with differential rights, subjecting private companies to any onerous rules in this regard will hamper investment structuring.

Insider Trading Restriction on Shares of Private Companies

Another feature of the 2013 Act is the applicability of insider trading restrictions on shares of a private or public unlisted company. The 2013 Act mandates that no director or key managerial personnel[15] of a company shall engage in insider trading; which is described to include, among other things, subscribing or selling to shares by such persons or providing any price sensitive information to any person. This restriction will impact deal structuring since almost every deal in the unlisted company space would involve sharing of information by directors or key managerial personnel or subscription or sale of shares by promoters who are normally in an executive capacity within the company.

Grandfathering

While some of the changes described above are onerous and make deal structuring a challenge, the absence of clear grandfathering provisions in the 2013 Act is a cause for concern especially when assessed in light of the restrictions on creation of classes of shares or layers of investments. As the 2013 Act[16] merely grandfathers acts validly done under the 1956 Act which are not inconsistent with the 2013 Act, there is no clarity on whether the ‘inconsistent’ provisions would have prospective or retrospective applicability. This is relevant to determine whether existing structures and transactions consummated pursuant to the extant law would have be wound up or restructured for aligning them with the provisions of the 2013 Act. Apart from the operational inconvenience in unwinding existing structures, the cost implications for such unwinding could be significant.

Concluding Remarks

The government has been advocating that the 2013 Act is a positive step towards greater accountability and transparency for corporate India. But, in order to achieve accountability and transparency, the legislature may have restricted the ability of corporate India in structuring deals. While we hope that the rules that are to be prescribed by the government dispel some of the uncertainty created by the 2013 Act, certain provisions clearly need to be revisited by the legislature.

The views expressed herein are solely those of the author and have not been endorsed, confirmed, or approved by XBMA or any of the editors of XBMA Forum, nor by XBMA’s founders, members, contributors, academic partners, advisory board members, or others. No inference to the contrary should be drawn.