When a company is created which results towards investment by more than one person into the company, a shareholders’ agreement is essential. Generally, the shareholders enter into such agreement during the registration of the company, however when it comes to the upcoming/new investors, the existing and the new investors may enter into and execute a fresh shareholders’ agreement at any time during the life of the company.
By entering into a shareholders’ agreement, the shareholders can regulate the exercise of their rights in relation to the company and commit to how they will behave and run the company. It shall be the board of directors to manage the company through its decision on a day-to-day basis, however, in order to have the main control in some cases, the shareholders can reserve certain important decisions and restrict or limit the decision-making power of the board of directors with respect to certain matters towards the management of the company.
A shareholders’ agreement is an instrument that sets out the limitation which the shareholders would want to control, as far as possible, in certain cases including but not limited to changes to the articles of association, alteration of share rights, increase or reduce the amount of share capital, etc. Moreover, a shareholders’ agreement is also effective towards protecting the interest of minority shareholder. By incorporation of proper provisions, all important changes in the company will be bound to be made by the consent of all the shareholders and not just by the standard position i.e. by majority voting rights.
It is to be noted that shareholder agreements differ from company bylaws. Bylaws work in conjunction with a company’s articles of incorporation to form the legal backbone of the business and govern its operations. A shareholder agreement, on the other hand, is optional. This document is meant to be executed by and for the shareholders, in order to outline their rights, interests and obligations in the Company.
Key components of a Shareholders’ Agreement
It is always recommended that a shareholders’ agreement should be drafted on a comprehensive manner. Even though each agreement will be custom tailored to each individual business, all agreements need to include certain standard key components. These components shall focus on clarifying how the business will be run, how to resolve issues between shareholders and what each shareholder’s responsibilities and benefits are. In this regard, shareholders’ agreements shall contain the following key provisions:
Board of Directors and Board meetings
It is highly recommended that the following provision shall be included in the shareholders’ agreement with regard to the Board of Directors:
Composition of the Board of Directors: As per section 149 (1) (a) of the Companies Act, 2013 (the “Act”), a company shall have board of directors which shall consist of minimum 2 directors for private company and 3 directors for public company. The maximum number of directors shall be 15, which can be increased by passing special resolution of the Company. The company shall also comply towards appointment of an ‘Independent Director’ as may be applicable under the Act.
Removal and Vacancy: This provision will lay down the mechanism for under which a director from the Board can be removed. Additionally, this provision shall also provide the procedure of vacation of the office by the director.
Further, the provision shall also lay down mechanism for conducting board meeting as provided below:
Number of Board Meetings: Section 173(1) of the Act mandates a company to conduct at least 4 Board Meetings in a year, wherein each meeting shall be held at an interval of 120 days from that of the previous meeting. This understanding shall be provided in the shareholders’ agreement
Notice: Under Section 173(3) of the Act, each director shall be given at least 7 days’ prior notice in writing at his/her registered address. Additionally, the agenda specifying the matters which shall be conducted in the respective Board Meeting shall also be provided along with the notice.
Quorum: The quorum for a meeting of the Board of Directors of a company, under section 174 of the Act, shall be 1/3rd of its total strength or 2 directors, whichever is higher. In this regard, and the participation of the directors by video conferencing or by other audio-visual means shall also be counted for the purposes of quorum.
Circular Resolution: Section 175 of the Act empowers the company to pass a circular resolution which will be considered as valid and effective as a resolution duly passed at a meeting of the Board.
Shareholders’ General Meeting
Pursuant to the provisions of the Act, a general meeting can be ordinary as well as extraordinary. Ordinary meetings (also known as annual general meeting) are convened once a year under section 96 of the Act. Generally, the ordinary meeting is conducted for the approval of the corporate management, the previous year’s financial statements, and the allocation of profits or losses. The rest of the meetings are extraordinary in nature.
Notice: Under Section 101(1) of the Act, a general meeting can be conducted by giving at least 21 days’ prior notice in writing. However, the general meeting can be conducted at a shorter notice by complying with the conditions provided under the section 101 of the Act. Every notice for general meeting shall be annexed with a statement as provided under section 102 of the Act.
Quorum: The Company has the right to determine the quorum of a general meeting in its articles. Unless provided in the articles, the quorum of a general meeting shall be in accordance with section 103 of the Act. The provision shall also state and permit the participation of the shareholders through video conferencing or by other audio-visual means for the purposes of quorum.
Reserved Matters
The shareholder agreement should set out issues that cannot be passed without getting the approval of all signatories and not just majority support. By creating a list of reserved matters, all shareholders are given the chance to vet certain transactions to determine if they are prejudicial to their investment.
Matters including but not limited to changing share capital, acquiring or disposing of certain assets, taking on new debt, paying dividends, and changing the articles of association and memorandum of association are usually covered under this provision.
Shareholders’ information right’s provision
It is recommended that a shareholders’ agreement should include a requirement stating that shareholders are entitled to regular updates on the company’s performance through quarterly reports and an annual report. It should state the specific period when the reports should be sent out to shareholders. The agreement should also state when shareholder meetings will be held and the time, date, and venue of the meetings. This provision is important specifically for a shareholder who is not a director and has very limited rights under the Act to receive information. To put simply, the information provided to such shareholder are not much more than the information pertaining to a right to receive the accounts which are to be laid before the annual general meeting for approval.
Accordingly, it is important, particularly for minority shareholders, to include a right to receive information concerning the conduct of the business. This may either be drafted as a right to receive specific information (e.g. monthly/quarterly management accounts; cash flow projections; annual budgets etc) and/or a broader right to receive any information concerning the conduct of the business which such shareholder may reasonably request. In some cases, particularly where the minority shareholder is an investor, if a shareholder is not provided with the relevant information, he/she may have a right to enter the business premises of the company, access and copy records, interview employees and indeed appoint consultants on his behalf to investigate and report on the conduct of the business of the company.
Provision related to Dividends
Under Table A Articles as well as in most standard articles of association, dividends are recommended by the directors and approved by the shareholders in general meeting. Interim dividends are recommended and paid by the directors and are ratified by the shareholders in general meeting. The important point here is that in either case no dividends will be paid unless the board of directors firstly recommends the payment of a dividend. Where there exist mala fides intention on the part of the board of directors, it is extremely difficult (if not impossible) for a minority shareholder to insist on the payment of dividends to him/her. Hence, in this regard, it is been standard practice to include in a shareholders’ agreement a provision whereby a certain amount of the profits of a company must be declared and paid out in each year by way of dividend. It is also to be noted that usually in the early-stage of business of the companies, the operation of this clause is temporarily suspended for a specified period to allow the company to reach a position where it is making a certain level of profits or to use retained profits for development/expansion. Hence, this provision may not be present in a shareholders’ agreement executed at the time of incorporation of the Company
Transferability
This can be considered as a one of the most important content in the shareholders’ agreement. While the shares of a public listed company are known to be freely transferable, however, such rights do not exist with regard to the shares of a private limited company.
Based on the commercial understanding between the parties, the provision for restriction of transfer of shares can be provided in various ways. One restriction on which both parties agree is to bring a ‘lock-up’ provision in accordance with which, the shareholders are restricted from selling and/or transferring their respective shares to any third parties for a specified period of time. While this provision is meant to help the investors/buyers for a smooth transition, it also protects the older/startup shareholders from the new investors and allows them to benefit from and use their investment efficiently.
The typical set of restrictions named the ‘right of first offer’ or the ‘right of first refusal’, provide shareholders the option to keep their company exclusive and closed to new shareholders at a certain level. While the right of first offer requires the selling shareholder to first negotiate the sale of his shares with existing shareholders before offering such shares to third parties, the right of first refusal provides the non-selling shareholder to be able to buy the shares on the same terms or better terms with the third-party purchaser offering to buy those shares. Both restrictions are regulated with time-limits and procedural rules which allow the selling shareholder to proceed with the sale of his shares if such rules or time-limits are not respected.
Another set of restrictions named the ‘drag-along right’ and ‘tag-along right’, provide entitled shareholders to sell their shares together with the selling shareholders or to require other shareholders sell their shares together with him if relevant conditions are met. ‘Pre-emptive rights’ may also be an option in order to provide certain shareholders, usually investors, to buy future issuances of the company with certain exemptions and/or as an anti-dilution protection.
Exit Provision
An important aspect of shareholder protection is their exit rights. In a public company, an unhappy shareholder can sell his/her shares on the stock exchange and exit the company. However, it is not so easy for a shareholder to dispose of his/her shares in a private company. This is especially when the company’s constitution restricts the right of shareholders to transfer their shares. Therefore, exit clauses are often incorporated into the shareholder agreement to ensure that shareholders in a private company would be able to dispose of their shares and exit the company in a manner equitable to all shareholders.
Non-Compete & Non-Solicitation Provision
It is quite common to find in a shareholders’ agreements (especially in a shareholders’ agreement entered into in connection with a venture capital investment), various restrictions on promoters which restrict them for the period whilst they hold shares in the company and for a certain period thereafter from:
- competing with the business(es) carried on by the company;
- soliciting customers of the company; and
- soliciting employees of the company.
These restrictions are frequently given for the benefit of the investing party or in other types of shareholders’ agreements for the benefit of the company itself. In early-stage businesses which are heavily dependent on the promoters involved and their knowledge and contacts, these kinds of restriction plays an important part in demonstrating a promoter’s commitment to the company. Apart from venture capital situations, these provisions are also important as many businesses are particularly vulnerable to a promoter departing and setting up a business elsewhere and possibly also hiring some of the employees of the existing company and then competing with the existing company.
These types of restrictive covenants are only part of a package of measures designed to ensure that the promoters are committed to the business of the existing company. It is important to note that these type of restrictive covenants must be very carefully drafted and, in simple terms, where they continue in effect after a promoter ceases to be employed in the company. If the application of the restrictive covenants are too broad (for suppose, in terms of their geographic, sectorial or temporal application) they may be subject to challenge by the affected party on grounds that they are in breach of doctrine of restraint of trade under the Indian Contract Act, 1872 or in breach of the provisions of the Competition Act, 2002.
Amendment and Termination
The process of amending or terminating the shareholder agreement should be provided in the agreement. For example, the shareholder agreement may be terminated upon the dissolution of the company, based on a written agreement, or after the lapse of a specific number of years from the date of the agreement.
Enforceability
It is to be understood that there are neither any specific statutory sources to govern the shareholders agreement nor there are any legal formalities prescribed by law for its creation. Moreover, it has been observed that there are also no consistent case laws to govern the agreement. The validity of the shareholders’ agreement are partially guided by the Indian Contract Act, 1872 and other legal principles.
In order to claim remedy under the Act, often the clauses of the shareholders agreement are brought in conformity with the articles of a company or the articles are altered after the shareholders enter into the agreement.
This shareholders’ agreement cannot be enforced against any third party. However, in order to enforce the agreement against such third person in the matter concerning to the non- company related issue, it has to be first incorporated in the articles of the company. Articles of a company are public in nature i.e. it is easily accessible to the third party and thus he would be legally bound to read the articles before entering into any transaction.
In the case of V.B.Rangaraj v. V.B Gopalakrishnan [AIR 1992 SC 453, [1992] 73 CompCas 201 (SC)], the fundamental question which was considered in the case was related to the dominance of article of association of a company over shareholders agreement. The Supreme Court held that the restrictions to the transferability of shares are to be mentioned in the articles of association and since in this case it was not mentioned in articles but in shareholder’s agreement made it unenforceable against the defendants.
Moreover in the case of Mafatlal Industries Ltd. v. Gujarat Gas Co. Ltd & Ors [(1999) 97 CompCas 301 (Guj) : (1998) 5 CompLJ 223 (Guj)], the question was raised before the Gujarat High Court pertaining to enforceability of the shareholders’ agreement regarding granting of pre-emption rights in a public company. The defendants had, pursuant to the reasoning of the Supreme Court in the case V.B. Rangaraj v. V.B. Gopalakrishnan, contended that, in view of the provisions of section 82 and 111A of the Act, the Supreme Court had already declared that shares are freely transferable with no restriction on the shares. On this, the plaintiffs had retaliated that the judgement of the case would not be applied as it was concerned to the private company and the concerned company in this case was a public company. The Gujarat High Court had upheld the Supreme Court’s judgment in V.B. Rangaraj v. V.B. Gopalakrishnan, stating that it will apply in much greater force to the case of public company. In this regard, the Gujarat High Court has stated that the pre-emption agreement which is not incorporated in the articles of association was held to be unenforceable.
The articles of association constitute a statutory contract between the shareholders and the company. The articles tend to bind each and every member of the company even though there is no individual contract between the members. The agreement which is inconsistent with the provisions of the Act would be considered to be void as per section 6 of the Act. Pursuant to the abovementioned judgements, it is apparent to state that, in case of both public and private company, the provisions of the shareholders agreement have to be incorporated in the articles of association, in order to create its enforceability against the members.
Author: Dippyaman Bhattacharya, Associate.
Disclaimer: The content of this article is intended to provide a general guide to the subject matter and that the same shall not be treated as legal advice. For any queries, the author can be reached at dippyaman@samistilegal.in
