This article has been written by Shubham Khunteta, a student of National Law University Odisha, Cuttack on the newly specified clause of entrenchment in the Companies Act, 2013. It analyses the relevance of it to the class of shareholders and also discusses penalty and adjudication in case of non-compliance of such clause.

Introduction

The word ‘entrenchment’ in the newly incorporated entrenchment provisions in the Companies Act 2013 has not been defined therein. However, according to the Oxford dictionary, the word ‘entrench’ literally means firmly added, surrounded and a vital part of something that may be in the constitution document of the company like the Articles of Association. These provisions have been added in the act to give voice and strength to the vulnerable and inferior party so as to not allow discretionary decisions in the company in various areas until the consent of such members if prescribed in the entrenchment clauses of the AOA, is taken. It makes certain amendments either more difficult or impossible, i.e., inadmissible. It may require a form of a supermajority, a referendum submitted to the people, or the consent of another party.

A Company is a group of persons that comes together to create their wealth by making joint and mutual decisions for the benefit of each other, but it is likely that majority shareholders will try to impose their decisions on the others in the working of company, thereby affecting the mutual decision-making power of the shareholders and violating their rights to have a say on matters especially relevant and crucial for them.

Considering such problems, the Companies Act, 2013 incorporated  entrenchment provisions under Section 5(3) to give a helping hand to the minority from the dangers of majoritarianism and to prevent the creation of legal dictatorship.

In the view of these provisions, it is not binding on the company to incorporate such a clause as it is discretionary. However, if such entrenchment provisions are incorporated in the Articles of Association of the company, then the company can’t exercise particular power, without the restrictive conditions for decisions are complied with.

 

Concept and Interpretation of Entrenchment provisions

The Government inserted a new section, i.e., Section 58(2) in the Companies Act which gave the companies the discretionary power to incorporate in their AOA entrenchment provisions so as to make it cumbersome and more regulatory for the majority and the people at the helm of the company, restricting their power to control the company at their own whims and fancies.

Legal dictatorship that was previously available under the former Companies Act has been restricted by this section and now minority members can insist on the majority to take their grievances into consideration and not make decisions unless minority views are put on board. However, it is to be understood that these provisions are to be provided for in the AoA at the discretion of the company, but once it is so provided, it is to be complied with at any cost and any decision taken in violation of the entrenchment clause in the AOA would be construed as abuse of majority power and violation of the Act.

The Supreme Court in V.B. Rangaraj vs V.B Gopalakrishnan[1] has held in this regard that a private agreement between shareholders would not bind the Company unless the Articles of Association of the Company provides for such limitations. The new act refers to “the Amendment of specified clauses of Articles of Association” as the entrenchment Clause. The entrenchment clause, nevertheless, needs to be in agreement with the Memorandum of Association of the Company and the Companies Act, 2013. Any entrenchment Clause which is against the provision of Companies Act, 2013 or Memorandum of Association is void and unenforceable.

Types of Entrenchment

Entrenchment can be either absolute or conditional. Absolute entrenchment implies that certain provisions are unalterable and impossible to change unless there is a court/tribunal order. This entrenchment is not provided for in the Companies Act, 2013. Conditional entrenchment, on the other hand, implies that certain provisions can be altered, subject to fulfilment of certain conditions or compliance with specific procedures (For example, approval by more than 75% members instead of the usual special majority of 75%.).

Procedure for Incorporation of Entrenchment Clause

These provisions shall only be made either on the^[2] –

1. Formation of the company; or
2. By an amendment to the Articles of Association by all the members in case of private company and on passing a special resolution in case of public company, if it is already formed.

 

It means that companies will have to incorporate these provisions in the manner aforementioned only. After the incorporation of these provisions in the articles, the company has to give a notice to the registrar in the following ways according to the Company (Incorporation) Rules, 2014 –

1. In the case of a newly formed company, notice is to be given in the Form No. INC.2 for a ‘one person company’ (OPC) or Form No. INC. 7 for companies other than OPCs along with the fees as specified in the Companies (Registration office and fees) Rules, 2014 at the time of the company’s incorporation.
2. In the case of a company already in existence, Form No. MGT. 14 is to be filed within 30 days from the date the entrenchment articles are incorporated in the AoA along with the fees as specified in the Companies (Registration office and fees) Rules, 2014 under the provisions of Section 11^[3] as applicable regarding registration of certain resolutions and agreements with Registrar of companies.

Instances of Entrenchment Clause: Provisions of Articles

1. Provisions as to proportional representation (Section 163): Before coming into force of the section about entrenchment, the appointment of directors in a company was given effect through a simple majority vote, thereby depriving the substantial minority to place even a single director on the board. Now, to put control on that, entrenchment clauses can be used by the minority to prevent their exploitation and set a rider before the exercise of any such power by the majority.

Although the protection is also available under Sec 163 of the Companies Act, 2013

2. The power of shareholders/co-venturers/any person to nominate/appoint directors on the Board of a company.
3. This provision provides that any affirmative rights such as issue of shares, creation of new subsidiaries, borrowing more than a particular limit can only be done with the consent of minority^[4].

For example, If PQR Company subscribes by investing in XYZ, a Private Ltd. company in 10% terms, tomorrow if XYZ private limited approaches any Bank for a loan, the bank officials would read the Articles & would ask to get the consent of PQR Company. Now, if there is no entrenchment provision, then ‘XYZ’ may, after passing a special resolution remove the minority right and can borrow beyond the limit.

In order to control it, the entrenchment provisions are usually compelled by the minority to make the majority responsible and the minority in these provisions can get incorporated a clause saying that borrowing beyond a particular limit or issuances of shares is to be done only after the requisite consent of minority has been obtained.

Penalty

Since no specific penalty or punishment is prescribed for infringement of section 5, general penalty suggested under Section 450 of the Act is applicable. Accordingly, the company, as well as its officer, who is in default or such other person shall be punishable with a fine up to Rs.10, 000/-.^[5]  For continuing offence, they are punishable with a further fine up to Rs.1, 000/- for every day after the first during which breach continues.

It may be noted that for a second or a subsequent breach of the provision of this section, if made within a period of three years, then the company as well as its officer who is in default shall be punishable under Section 451 with twice the amount of fine in addition to any imprisonment provided for the offence^[6].

Adjudication of Penalty Related Disputes on Violation of Section 5

Under Section 454, the officer appointed by the Central Government, not below the rank of Registrar of Companies, may adjudge and impose a monetary penalty for violation of this section. However, before imposing any penalty, an opportunity of hearing shall be given to the Company and its officers^[7].

Conclusion

It can be seen from the provisions related to entrenchment that these newly incorporated provisions are important changes made. Restrictions and conditions on transfer of securities in a private company by a contract^[8]  can be enforceable under it, and it would not be against the spirit of the private company feature of non-transferability of security. This agreement need not be provisioned in the Articles as was the case earlier. This can be one of the entrenched provisions in the AOA that the agreement may be tweaked in accordance with the minority rights.

Therefore, at last, it can be said that the government by incorporating the entrenchment provisions in the Companies Act, 2013 gave the breath to live to the minority and vulnerable people and power to negotiate fearlessly with the majority in their interest, although these provisions are discretionary on the part of the company. However, the minority shareholders due to this incorporation into the Companies Act of this provision can insist and bring on the ground the majority to concede with the minority and truly stand to the utmost duty, i.e., “Fiduciary duty” of the majority to minority.

 

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Footnotes:

[2] Sec 5(4) of the Companies Act, 2013

[3] See, Section 117(3) of the Companies Act, 2013 to know the application of provision.

[4] http://taxguru.in/company-law/entrenchment-clause-article-association.html

[5] http://pkpandya.com/section-5-articles/

[6] See, Sec 451 of the Companies Act, 2013

[7] See, Sec 454 of the Companies Act, 2013

[8] See, Sec 58(2) of the Companies Act, 2013