Entrenchment of the constitutional documents of a company came into sharp focus globally about a decade ago. After the United Kingdom made a significant change in its company law India followed suit and the concept of entrenchment was specifically introduced for the first time in Indian company law by the Companies Act, 2013. Read on to find out more.
History has always been witness to civilisations, cultures and communities taking tough protective measures against any perceived threat to its essence or existence. Wars have been fought and lives have been lost in valiant attempts at thwarting these threats. In our modern civilised world, the pattern continues but with a small difference. The essence or existence of any State is now enshrined in its Constitution. The Constitution lays down the political principles of the State and the rights and liberties of the people it governs. Many countries across the world have therefore been zealous in protecting their Constitution from amendments that could dilute or extinguish the fundamental principles stated therein. The protection is introduced in the form of “entrenchment”.
Entrenchment is explained by the Oxford English dictionary as ‘to establish so firmly that change is difficult; to apply extra legal safeguards (to a constitutional right guaranteed by legislation).’ Entrenchment provisions ensure that certain constitutional amendments would require either a direct vote by the entire electorate (“referendum”) or a super majority. This effectively ensures that the Constitution of a State remains sacrosanct and out of bounds for amendment seekers unless they are able to garner the requisite support.
In the corporate world, the essence or existence of a company is embodied in its Memorandum and Articles of Association which state its name, registered office, objects, capital, liability of members and also the regulations for management of the company. The Memorandum and Articles of Association together comprise the Constitution of the company. Entrenchment with regard to a company’s Constitution would mean introducing additional safeguards for its alteration in the form of restrictive conditions or procedures.
Entrenchment of the constitutional documents of a company came into sharp focus globally about a decade ago. In 2006, United Kingdom saw widespread reform in English company law when the (English) Companies Act, 2006 (“2006 Act”) superseded the (English) Companies Act, 1985 (“1985 Act”). With 1300 sections and 16 schedules in it, the 2006 Act was a major consequential legislation and made sweeping changes in English company law. It was fully implemented from October 1, 2009. While the 1985 Act allowed English companies to entrench certain portions of their constitution by including it in their memoranda and stating that they could not be altered, such absolute entrenchment was disallowed by the 2006 Act for companies incorporated after October 1, 2009. The new Act replaced absolute entrenchment with a diluted version of it. It allowed companies to provide for entrenchment in their articles on a conditional basis. Section 22 (1) of the 2006 Act stated that a company’s articles may contain provision (“provision for entrenchment”) to the effect that specified provisions of the articles may be amended or repealed only if conditions are met, or procedures are complied with, that are more restrictive than those applicable in the case of a special resolution.
Entrenchment of articles was undoubtedly, a significant change that the United Kingdom embraced in its company law. After the enactment and subsequent implementation of the (English) Companies Act, 2006, several jurisdictions across the world took note of its reformative provisions and considered amendments on similar lines in their own corporate legislation as well.
A few years later in 2013, India followed suit and replaced its archaic company law which had been in existence for more than fifty years, with a new revamped version. The concept of entrenchment was specifically introduced for the first time in Indian company law by the (Indian) Companies Act, 2013 (“CA 2013”). The CA 2013 was enacted on August 29, 2013 to “consolidate and amend the law relating to companies” and was intended to replace the Companies Act of 1956. The CA 2013 initially became effective in small measure on September 12, 2013 but largely became effective from April 1, 2014. This newly consolidated and amended CA 2013 made several significant changes that impact Indian companies and their stakeholders in the conduct of business.
One such change in the form of entrenchment was introduced in Section 5 of the Act which deals with Articles of Association of a company. Sub section (3) therein provides that the articles may contain provisions for entrenchment to the effect that specified provisions of the articles may be altered only if conditions or procedures as that are more restrictive than those applicable in the case of a special resolution, are met or complied with. Sub section (4) provides that the provisions for entrenchment referred to in sub-section (3) shall only be made either on formation of a company or by an amendment in the articles agreed to by all the members of the company in the case of a private company and by a special resolution in the case of a public company.
The CA 2013 does not define “entrenchment”. There is also no explanation provided in Section 5 or elsewhere in the Act on what specifically would be considered as a provision for entrenchment. Reliance has therefore to be placed on the dictionary meaning of entrenchment along with the wording of Section 5 to understand the concept as put forth by the law makers. In the absence of any definition or explanation on entrenchment the question whether or not a particular restrictive provision in the articles is a provision for entrenchment, would need to be decided on the basis of the specific wording used in the article and the interpretation that could be attached to it.
Section 5(3) is an enabling provision and there is no legal compulsion on companies to include entrenchment provisions in the articles. It is an option given to a company which it may or may not utilise. Ordinarily, companies who desire to alter their articles can rely on Section 14 of the CA 2013 which gives them the statutory power to do so by a special resolution. However for those companies who wish to further fortify their constitutional documents from alterations, Section 5 is a boon as it gives legal sanction and recognition to inclusion of restrictive conditions or procedures that make amendment of articles, tougher to accomplish.
The erstwhile Companies Act of 1956 did not contain any specific provision for entrenchment. Yet, to give comfort to foreign investors, it was common practice for Indian companies to include restrictive conditions or higher affirmative vote thresholds in Investor Agreements as safeguards for such investors. Courts have in the past recognised and enforced such provisions under that Act. With entrenchment now having legal sanction, the enforceability of such provisions will be reinforced by Section 5 of CA 2013.
Under the CA, 2013 entrenchment provisions can be included in the articles either in the initial stages itself when the company is incorporated or subsequently during its lifetime. In the latter case the entrenchment provisions can be included only by an amendment in the articles. In case of a private company, an amendment for the purpose of including entrenchment provisions would need the unanimous approval of all the members. The approval threshold is slightly relaxed for a public company, in which case a three-fourth majority by a special resolution will suffice. The CA 2013 does differentiate between the voting majority limit prescribed for such approval, depending on the private or public status of the company. The concession in voting majority extended to a public company is presumably based on the logic that its widespread shareholder base may make it practically impossible for it to secure a unanimous approval. On the flip side, by dispensing with the unanimous approval of shareholders, the CA 2013 has put minority shareholders in a public company at a risk of having entrenchment thrust on them by a united majority.
A provision for entrenchment can be made only with respect to alteration of articles. Section 5 makes no reference to the Memorandum of Association. Nonetheless when a provision for entrenchment is introduced in the articles, it will have to be in conformity with the Memorandum of Association and the provisions of the CA 2013. An entrenchment provision cannot in any manner be contrary or repugnant to the provisions of the CA 2013 as in that case, the Act will override such provision and render it void and unenforceable to the extent to which it conflicts with the Act.
An entrenchment provision does not in any manner imply or mean that the specified articles cannot be altered at all. Alteration of articles is a constitutional right given to the members of the company and it cannot be taken away. An entrenchment provision only means that the exercise of this right has been made subject to conditions that are tougher to meet or comply with, as compared to a special resolution which would ordinarily suffice for such alteration.
Since an entrenchment provision is founded on conditions or procedures that are more restrictive than a special resolution, two inferences may possibly be drawn from it. First, entrenchment can only be with respect to matters that would require the consent of members by a special resolution. Second, it would need a consent threshold that is higher than three times the number of votes as would be required by a special resolution. That being said, inclusion of restrictive conditions such as an affirmative vote from a particular member or group of members or particular class of shareholders where the company has more than one class of shares is also possible.
The wording of Section 5 makes it clear that a provision for entrenchment can be made only with respect to alteration of specified provisions of the articles. This effectively means that all the provisions of the articles cannot be entrenched as doing so would conflict with the statutory power given to companies by Section 14 of CA 2013 to amend their articles by a special resolution. Entrenchment of the entire articles could also impact the efficiency of business operations if urgent and necessary alterations in articles become cumbersome to achieve.
Whenever a company introduces entrenchment provisions in the articles, either on its formation or during its lifetime, the company has to notify the Registrar of the same. Rule 10 of the Companies (Incorporation) Rules, 2014 provides that when an entrenchment provision is included in the articles at the time of formation of the company, then the notice to the Registrar has to be given in Form INC-2 by a One Person Company or in Form INC-7 by a company other than a One Person Company. When an existing company amends it articles to include an entrenchment provision, the notice to the Registrar has to be given in Form MGT-14 which has to be filed within thirty days from the date of entrenchment of articles, along with the fees prescribed in the Companies (Registration Offices and Fees) Rules, 2014. Such notification ensures that the Registrar and any person who views public documents filed with the Registry will have constructive notice of the entrenchment provisions in the articles. The awareness assumes importance for prospective members or those who are dealing with the company.
In the past, the enforceability of restrictive conditions or procedures was often tested in courts as there was no specific legal provision for entrenchment. Depending on the facts and circumstances of the case, courts have at times recognised and upheld such restrictive conditions as valid and enforceable while in some cases they have been struck down as unenforceable. In this context, the Supreme Court in the landmark judgement of V.B Rangaraj vs. V.B Gopalakrishnan and Others (AIR 1992 SC 453) held that the only restriction on transfer of shares of a company is as laid down in the articles, if any. A restriction which is not specified in the articles is therefore not binding either on the company or on the shareholders. A private agreement which imposed additional restrictions on the transferability of shares contrary to the provisions of the articles of association was therefore not binding on the shareholders or on the company. In another judgement, the Punjab and Haryana High Court in Amrit Kaur Puri vs. Kapurthala Flour, Oil and General Mills Co. P. Ltd (1984 56 Com Cases 194 P&H) held that an article of a private limited company which provides for a higher quorum for a meeting of the Board of directors than that provided under the Companies Act, 1956 would not be repugnant to the provisions of the Act and must be conformed to.
With Section 5 now providing legal sanction and recognition to entrenchment clauses, it will to a large extent reduce potential litigation on the enforceability of such clauses. However it must be remembered that CA 2013 is still nascent and Section 5 has come into effect only a year ago on April 1, 2014. Several legal issues could arise on the way forward as companies start fortifying their constitutional documents through entrenchment. Questions with regard to what specifically does or does not comprise entrenchment or the extent to which such restrictions could be imposed are most likely to emerge for final determination by Courts. The judicial pronouncements of the future may then serve as a beacon light for this new law.
www.grandmasters.in | 8 Years & Counting
www.rcls.in | 8 Years & Counting
www.itlegalsummit.com | 8 Years & Counting
www.bfls.in | 8 Years & Counting
www.maels.in | 8 Years & Counting
www.plcs.co.in | 8 Years & Counting
Copyright © 2020 Lex Witness - India's 1st Magazine on Legal & Corporate Affairs Rights of Admission Reserved
