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This article is written by Shobhna Aggarwal, from Banasthali Vidyapith. This article seeks to qualitatively identify the investor control rights typically negotiated by PE funds.

Introduction

Private Equity and Venture Capital have been the driving force of growth in the global economy for decades. But the prevailing situation denotes that global private equity and venture capital funds have gained momentum as the most significant forms of investment in companies. With the motive of having a share in the profit of the company either through equity or convertible preferred stock or convertible debt, the Public Equity Funds invest in Indian companies. In order to ensure an efficient outcome, everything requires a set of guidelines and rights. Likewise in order to deal with the public Equity Funds and Investment related disputes and dealings, a series of control rights are essential and are not essential for the day-to-day management of the company.

These rights are provided in the form of board nominations, quorum requirements, and veto powers, by means of which the investors do not become an integral part of the company but get the access to participate in the governance of the company. Private Equity funds are stirring up corporate growth rapidly for which apprehension on the enforceability of the rights is attracted. In this regard Company, Law, and Contract Law go hand in hand. Studies reveal that courts uphold the observance of general corporate law and norms while deciding on company law disputes.

How strong are the investor rights in India?

Under the Companies Act 2013, a company is bound to register the constitutional documents i.e. memorandum of association (MOA) and articles of association (AOA). Along with it, a company is also made a party to the Shareholders Agreement to make its provisions obligatory on the company. The rights and obligations of the PE investor in a company are determined under the shareholders’ agreements.  In this purview Indian courts tend to follow the principle of autonomy and the concomitant freedom of parties to contract, certain limitations are provided. The issue of investor rights and their protection was first discussed in V.B. Rangaraj Vs. V.B. Gopalakrishnan And Ors, which established the principle of notwithstanding anything contained in the agreement between the parties beyond what is incorporated in the AOA.

A PE investor seeks to obtain the following rights under the shareholders’ agreement:

Appointment of nominee director

Depending on the shares in the company which is supported by deadlock provisions that vary from 10%-15% extending to the majority of shares, the private equity investors usually have one or more nominees on the board. The presence of a nominee director of Private Equity investor is mandatory for the attainment of meetings at the Board Level, Shareholder’s Level, and Committee.

Rights to affirmative voting 

For the purpose of taking certain actions at the meetings i.e. Board Level, Shareholder’s level, and Committee level, prior written consent of the Private Equity investor is required by means of affirmative voting which is similar to veto rights of the public Equity investor.

Protection 

The Shareholder’s Agreement creates a protective shield for contingencies for ensuring appropriate utilization of funds towards a pre-determined business plan, comprising anti-dilution rights, a lock-in of promoter shares, pre-emptive rights in future fundraising, and preferential treatment on the occasion of liquidation.

Information and Inspection Rights

By virtue of being a member of the board, certain information rights are provided to the Private Equity investors but apart from that, the Shareholder’s agreement guarantees the right to receive or examine certain financial data or other related information.

Restrictions on Transfer of Securities

The existing restrictions provided by the Shareholder’s agreement are lock-in period obligations, right of first refusal or right of the first offer, drag-along rights, and tag-along rights. The promoters are imposed with lock-in obligations.

In the case of Dahiben Umedbhai Patel And Ors. Vs. Norman James Hamilton And Ors. it was held that since the securities of a private company do not possess the character of liquidity’ and are not ‘marketable securities’ as per the definition of ‘securities’ contained in Section 2(h)(i) of the SCRA, the provisions of the SCRA would not encapsulate private companies. The said judgment was upheld by the Supreme Court in 2013 in the case of Bhagwati Developers Private Limited Vs. Peerless General Finance and Investment Company Limited And Ors. The Apex Court affirmed that the definition of ‘securities’ in the SCRA did not envisage securities issued by private companies “notwithstanding the use of words ‘any incorporated company or other body corporates’ in the definition.” 

Another case that determined the question of application of SRCA to private companies, in the case of  Dahiben Umedbhai Patel And Ors. Vs. Norman James Hamilton And Ors. It was held that since the securities of a private company do not possess the character of liquidity’ and are not ‘marketable securities’ as per the definition of ‘securities’ provided in Section 2(h)(i) of the SCRA, the provisions of the SCRA would not encapsulate private companies. The said judgment was upheld by the Supreme Court in 2013 in the case of  Bhagwati Developers Private Limited Vs.  Peerless General Finance and Investment Company Limited And Ors. The apex court in the said case stated that the shares of a public unlisted company shall also be subject to the provisions of the SCRA.

Exit Mechanism

By means of negotiation, the Private Equity investor adapts any one or more of the following exit mechanisms, namely, Call Option, Put Option, Buyback of Securities by Company, Strategic Sale of securities to third party and IPO, etc. In this purview Indian courts tend to follow the principle of autonomy and the concomitant freedom of parties to contract, certain limitations are provided.

The issue of investor rights and their protection was first discussed in V.B. Rangaraj Vs. V.B. Gopalakrishnan And Ors., which established the principle of notwithstanding anything contained in the agreement between the parties beyond what is incorporated in the AOA. Another case in this regard is the World Phone India Pvt. Ltd. and Ors. Vs. WPI Group Inc, the general legal provision states that where AOA is silent on the existence of affirmative vote, it will not be possible to hold that clause in an agreement between the shareholders that would be binding without being corporate in the AOA. In respect to the said case the court held that even when a provision in SHA is not contrary to the Articles of Association of the Companies Act, 1995, it cannot be enforced if it is not mentioned in AOA.

Why is private equity funding a preferred vehicle for corporate growth?

The strategy of combining business and investment portfolio management lays the foundation for corporate growth. Its success is backboned by the unique buy-to-sell strategy which is appropriate for boosting undermanaged business that requires intensive care over a period of time. Due to the corporate capital gains taxes, private equity was benefited by an unfair tax advantage, which added to the profit. The value created by the private equity partners is portrayed through their high rewards. Over the years private equity firms developed their experience with turnarounds and techniques for improving revenues and margins which and as a consequence private equity funding established itself as the dominant vehicle for corporate growth globally.

How do contractual laws interfere with day to day management of a company?

In a company or a firm several small and big contracts are made. Every work that the firm undertakes results in a contract in some way or the other, providing certain rights and obligations to the parties. The contract is involved in almost any business dealing with a product or service, which makes contract law an integral part of the business by means of purchase, selling, reselling, or rendering service. The terms and conditions of these day-to-day dealings are also governed and checked by contract law that pertains to transactions between the parties. Contract law and Commercial law bring out the very essence of any business and its functions. For example, under the Contract of Agency, the Indian Contract Act provides that an Agent is under the duty to follow “local customs” which differs from place to place. This is also mentioned in the rules of International Trade Law by ICC.  Here the court would look into the varying degree of such relations and will decide accordingly.

Need to test contracted rights in courts

One of the essential aspects of our judiciary is that it checks and tests the laws that have been implemented or affected in a certain way. In theory, each and every statue is given equal importance but in general parlance, there is an ignorant attitude towards certain subjects, one such instance is contract law. However recent judgments contributed towards developing a clear overview for investors intending to exercise their contractual rights.  In Edelweiss Financial Services Limited Vs Percept Finserve Private Limited And Ors., the Court upheld the validity of the put option guaranteed to Edelweiss under the Share Purchase Agreement (“SPA“) executed between Edelweiss and Percept in December 2007. It was also held by the court that the put option cannot be said to be a forward contract due to this reason, the promoter was given some time to repurchase after the exercise of the put option.

These judgments played a vital role in setting out a framework of contracted rights that not only protects the investor’s rights but also ensures that the contract is made in accordance with all the legal provisions in this regard.

Effect of placing restriction on transfer of shares

One of the most important issues regarding the transfer of shares in private companies is the restriction on the transfer of shares in private companies. The Company Act 2013 does not provide for any specific restrictions. It is the discretion of the framers of the Articles to develop these restrictions and specify their scope and extent. A private company is an association of members working for the betterment of the company by building a relationship of Trust, Cooperation, and Accountability and the restrictions on the transfer of shares allow the members of a private company to protect the same. The court acts as the protector and preserver of these restrictions and paves way for the company to reach its ultimate aims and objectives. However, there are some threats to this. 

The restrictions room for uncertainty, for instance in the case of pre-emption rights with respect to the valuation of shares, ambiguity exists. Also, it must be ensured that the restrictions do not exceed the prescribed scope by the Articles. Certain powers have been provided to the directors to refuse to register a transfer but the given power is often found to be abused. Section 111 of the Act provides for certain remedies of abuse of power and along with it the board also keeps a check on it. Even though there have been efforts but concrete steps must be taken to check abuse and eradicate ambiguity created by these restrictions on the transfer of shares in private companies for the larger interest of the Indian economy.

Limitations of the Companies Act

Compared to the advantages of incorporation, the disadvantages are indeed very few. Yet some of them, which are in essence complications arising out of the privilege of trading with limited liability, needs to be pointed out.

Formalities and Expenses

The Companies Act 3013 lays down an extensive and complex legal procedure for the incorporation of a company, which involves a significant amount of time and money. Once the initial process of incorporation is completed, the company must be run and managed very strictly in consistency with the provisions of the act. Compared to the company act 2013, other businesses do not have to follow such a detailed and extensive set of rules.

Corporate Disclosures

Despite the extensive legal framework to ensure maximum transparency and disclosure of corporate information, the low-level members of the company have limited access to the company information and higher management. The top-level management tends to conceal facts which creates room for white-collar crimes. The act merely lays down any protection provision in regards to the same.

Separation of Control from Ownership

The small shareholders of the company do not play an active role in the decision-making process of the company due to the large size of the company that merely gets affected by the actions and opinions of a small group of people. Thus, the status of ownership in the company is of nominal significance.

Greater Social Responsibility

Due to the huge profit margin, these companies have a great impact on society at large. These companies often take part in social activities and due to this, they need to abide by certain social norms and contribute to the development of society.

Greater Tax Burden in Certain Cases

Compared to other types of companies, incorporated companies have to pay higher taxes, for instance, income tax is payable on the whole of its income at a fixed rate whereas other companies are charged at a gradual or slab rate.

One of the landmark cases in regards to taxes that have helped to eliminate uncertainty is the Vodafone International Holdings V. Union of India. In this case, the court recognized the principle of tax planning and also laid down certain guidelines. The following were:

  1. In absence of any statutory prohibitions, the business entities, and the individuals are given the liberty to make arrangements so as to reduce their tax liability.
  2. All the corporate structures established by multinational companies, should be made for business and commercial purposes only.
  3. If the facts and the circumstances of the case reveal that the corporate structure is a sham and intended to evade taxes then the corporate veil may be lifted.
  4. In neutral/investor-friendly nations, the presence of corporate structure should not lead to the conclusion that these are a means to avoid taxes. A holistic approach should be taken.

Winding up Procedure

The Companies Act 2013 provides for a detailed and prolonged process to explain the winding up of a company, which is time-consuming and expensive at the same time.

Important case laws

V.B. Rangaraj Vs. V.B. Gopalakrishnan And Ors. (AIR 1992 SC 453)

In the case of V.B. Rangaraj Vs. V.B. Gopalkrishnan And Ors. (AIR 1992 SC 453) while dealing with a conflict between a shareholders agreement (SHA) and the Articles of the company, the Indian Supreme Court took the view that the provisions of SHA imposing restrictions on share transferability even when consistent with the companies act are to be authorized only when they are incorporated in the Articles of the company.

Vodafone International Holdings v. Union of India (2012) 6 SCC 613 (India)

In the case of Vodafone International holdings V. Union of India (2012) 6 SCC 613 (India) the apex court seemed to have overturned this view in an obiter, holding that omission of rights available to specific shareholders and mentioned in an SHA but not in the Articles would not by itself render the rights unenforceable. The court held that even if such special rights are not mentioned in the articles, parties aggrieved by a breach of the provisions of the SHA could apply for remedies “under the general law of the land”. However, the court also cautioned against rights mentioned in the SHA which run contrary to the Articles. However, this view was not part of the primary discussion of the Vodafone judgment therefore it may be argued that this view may be treated as an obiter at best.

World Phone India Pvt. Ltd. And Ors. V. WPI Group Inc. 

In the case of World Phone India Pvt. Ltd. And Ors. V. WPI Group Inc. the Delhi high court said that the position taken in Vodafone was rejected and reliance was placed on Rangraj to hold that “the existence of an affirmative vote cannot be recognized without a corresponding amendment to the AOA”. Since then the Indian Supreme Court had rejected a special leave petition and did not entertain the matter of World Phone further.

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Conclusion 

It does not leave any room for arguments that Private Equity promotes growth but it is also undeniable that it is a critical system. In the Indian context, as a safeguard to self-opportunism of promoters Public Equity funds occupy minority positions. The negotiation between these investors comprises special rights as a part of these investments, which are specified in the articles of association of the investee company.

The case laws and prevailing provisions of company and security law in India combined show the present enforceability of these rights. The Company Act 2013, sets out the standard corporate laws and norms that need to be maintained. The minimum guidelines and standard of work that a company needs to maintain to carry out its activities are highlighted in the  ICA 2013. The company and its constituents, for instance, the Shareholders and the Directors may hold themselves to a higher standard, which should be recorded for the purpose of reference in the articles of the company. As a result of articles being a public document, it attracts investors and maintains goodwill, and adds momentum to private equity

References 


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