A private company is a legal entity, having a distinct legal personality. The pre-emptive rights granted to shareholders give a distinct character to a company. Here is a detailed account of reason, motive, object and jurisprudence of pre-emptive rights of the shareholders of a private company.
A private limited company is an incorporated entity which does business with the money of precisely limited number of individuals and does not involve the money of public at large. The identifying feature of a private limited company is the existence of certain requirements laid down by the statute under which it has been incorporated. For instance, section 3(l)(iii) of Companies Act defines a private limited company as a company whose articles of association contain the certain restrictions as:
Also a private limited company is compulsorily required to have articles of association.
However it is not necessarily a disadvantage or deprivation to be under an obligation to observe these restrictions. The private limited companies also enjoy a number of privileges for its non-public nature. Due to these privileges, a private limited company is often described as “an incorporated partnership, combining the advantages of both elements, the privacy of partnership and the permanence of the corporate existence”. The basic philosophy underneath these exemptions is the ‘respect of private character’ of the entity or in other words, ‘honouring intention of shareholders to enter into a business association with certain individuals’. However unlike partnership, a private limited company does not solely depend on principle of ‘trust in fiduciary relationship’. Rather it depends upon legal rights and obligations. And one such right available to the members for maintaining ‘intended privateness of their association’ is the pre-emptive right of shareholders.
“Pre-emptive rights of shareholders” means, the shareholders may have to be offered shares in a company before they are made available to the outsiders. This right can arise on number of occasions including allotment, transfer or transmission of shares. Such right is important in ensuring that a shareholder’s proportion of the voting and other rights in the company is not altered to his or her disadvantage. It can broadly be discussed under two heads, the Right of First Offer (ROFO) and the Right of First Refusal (ROFR).
ROFO is a pre-emptive right of a shareholder which in case of allotment of shares may arise from the provisions of the articles of association or under the statutory provisions. Under Company Act provisions, shares of a private limited company must be offered to existingmembers in proportion to their present holdings before being issued to anyone else. The offer must be in writing and the company must allow at least 21 days for the shareholder to take up the offer. However such statutory provision for ROFO rights is not accorded to the shareholders of a public company, simply because ‘public nature’ of public company gives more sanctity to the principle of ‘free transferability of shares of a public company’, the distinctive feature of a public company.
These pre-emptive rights are however not applicable in some circumstances like if the memorandum or articles of a private company exclude them or provide alternative provisions, e.g. to make more detailed provisions in respect of different classes of shares; or if the company passes a special resolution to exclude them; or the shares are issued for non-cash consideration or the shares are allotted within an employees’ share scheme. The shares could also be offered to the members who then waive their rights to them.
If there is a shareholder’s agreement containing some pre-emption provision, the agreement will be a contract between those members of the company who are parties to it and if the company itself is aparty to it, it will also be bound by the provisions of that agreement.
However, unlike in case of allotment, there is no statutory provision governing the preemptory right of shareholders of a private limited company in case of transfer and transmissions. But such right is quite commonly included in the articles of private companies and operates in a way similar to pre-emptive rights on allotment.
The importance of this right lies in the protection of specific interest of the members of a private company, which is not under the tight scanner of public authorities. Since a private company is exempted from obligation to hold a statutory meeting or filing a statutory report and it can issue shares to new outsiders, it is not under the constant vigil of public authorities. And all the private individuals holding shares of the company may not be well versed with abilities to scrutinize all the actions of the company. Even if some members are equipped with such competence, it may practically be impossible to review each of the action. And thus the element of ‘mutual trust’ takes the centre stage. However a private company being a legal person, having distinct legal personality from its members cannot be as closed a group as apartnership firm, but at the same time for its essentially ‘private nature’, it cannot be as open as a public company. Here law devises a novel way to ensure protection of ‘private nature’ of the company by preserving ‘proportion of voting rights’ of the members but at the same time restricting such preservation to not make it impossible to allow new capital or expertise from new sources. Hence new shares are first offered to existing members in proportion of their shareholdings, and then to outsiders only on ‘right of first refusal’ (ROFR) having been exercised by existing members.
ROFR is a pre-emptive option of a nonselling shareholder to purchase shares of a company that a selling shareholder proposes to liquidate. If the non-selling shareholder refuses to purchase such shares, the selling shareholder can sell the shares to a third party usually with a stipulation that the terms of such sale and more importantly the sale price should not be more favorable than those offered to the non-selling shareholder. In a nutshell, ROFR forms an integral part to investors’ protection in a shareholders contract.
However the pre-emptive rights, whether ROFO or ROFR though legally recognized in case of private limited companies, are highly controversial in case of the public limited companies. The High Court of Bombay in the case titled, Western Maharashtra Development Corpn. Ltd. v. Bajaj Auto Limited (MANU/MH/0109/2010) has held that pre-emptive rights go contrary to the principle of ‘free transferability’ of shares of a public limited company laid down in Section 111-A of the Companies Act, 1956, and, therefore, are not legally tenable.
Preemptive Rights (PRs) generally speaking are the rights of the shareholders to preempt/prevent certain actions from being taken by other shareholders. There are three types of PRs like statutory, contractual and judicially created PRs.
CONTRACTUAL PRs
Shareholders can agree amongst themselves to provide for additional PRs. These must become a part of the MoA and AoA of the company otherwise they are nonenforceable. Corporations have usually abused this also by not causing an amendment to their MoA and AoA andleaving a conflict between the provisions of shareholders agreements and MoA and AoA and in that case the charter documents prevail.
JUDICIALLY INTERPRETED PRs
The Modi litigation has made a very strong move towards enforceability of contractual PRs. The Division Bench of the Bombay High Court whilst deciding on the enforceability of the contractual PRs available to Messer holdings in the light of Section 111 has upheld that the enforceability of the same relying upon the view of the Hon’ble Supreme Court, in Madhusudan v. Kerala KamudiPvt. Ltd. , holding that the private holders arrangements do not amount to restrictions or the transferability of shares. The court has gone further to find that even if not incorporated into the Articles, the PRs would be enforceable between the shareholders that are party to the contract with a proviso that the restrictions which are to be enforced should not be such that, that impose restrictions on non-party shareholders.
THE PRESENT SCENARIO : WHY PRs HAS BECOME RELEVANT?
The PRs are typically found in financing situations. With a mushrooming of Private Equity (PE) in India there is a need for greater clarity on enforceability of PRs. Typically PE investors acquire substantial supervisory rights which have strong connotations of control and situation based PRs that control the ability of the owners of a company to introduce fresh investmentsor to take hard decisions. Most, if not all, of these provisions are being imported from the agreements that these PE investors have entered into or enforced in foreign jurisdictions. A glaring mistake in such importations has been that these provisions were not localized in accordance with Indian Law.
Another glaring mistake that has arisen from an overzealous protection of the investor rights /interests is failure to provide for the interests of the company itself. The recent judgment of the Hon’ble Bombay High Court in some part protects the interests of the company by holding such private arrangements to be unenforceable against the company if such provisions are not incorporated into the MoA and AoA of the Company. However no test concerning the interests of the company has yet been evolved. Intriguingly Indian Courts continue to make distinction between shareholder arrangements in a public and private limited company. Confusion arising out of this distinction is yet to be resolved and empirical analysis of this dichotomy clearly shows that private arrangements between shareholders are essentially “Private” and should be unaffected by the provisions of S. 111 A (which apply to Public companies). As a consequence of this dichotomy potential investors in a public company are deprived of the ability to protect their investments whilst potential investors in a private company are unable to do so creating a strange inequality.
However, in a later judgment of the same High Court in September 2010 titled M/s Holdings Limited v. Shyam Madanmohan Ruia (Ruia Judgment), the Hon’ble Court upheld the validity of such pre-emptive rights and opined that such rights do not violate the provisions of Section 111-A. The judgment discussed various judicial precedents including the judgment of the Supreme Court in Byram Pestonji Gariwala v. Union Bank of India and others (AIR 1991 SC 2234) wherein the Supreme Court observed that, “The freedom of contract generally exists and the legislature should not interfere except when warranted by public policy and the legislative intent is expressly made manifest”.
However it is submitted that the Ruia Judgment is contrary to the judgment of the Supreme Court in V B Rangaraj v. V B Gopalakrishnan (AIR 1992 SC 453) wherein it was held that shareholders agreements not stated in the articles of association are not binding either on the shareholders or on the public company. This judgment is also in contradiction with the principles laid down in Pushpa Katoch Vs. Manu Maharani Hotels Ltd. and Ors. (2006, 131 Comp Case 42 (Delhi) wherein it was held that pre-emptive rights are unenforceable even if incorporated in the articles of association, since such rights would be contrary to the principle incorporated in Section 111-A of the Companies Act.
How do companies generally try to circumvent the provisions of shareholder agreements to serve their interests?
Typically, shareholders not wanting to comply with transfer restrictions/ exit rights under shareholders’ agreement take refuge on the argument that such rights are either in violation of the principle of “free transferability” incorporated into Section 111-A of the Companies Act or that such rights / options are not “spot delivery contracts” and are therefore contrary to Securities Contracts (Regulations) Act, 1956 and SEBI notifications under that Act. The conflicting decisions of various high courts has only added to the legal quagmire on enforceability of such provisions in shareholders’ agreement, particularly in case of public limited companies.
In a PE transaction what covenants must be provided for, to reasonably secure the rights of a particular shareholder?
The covenants in each PE transaction would need to be negotiated based on the specifics of the transaction. However, broadly the basic rights that need to be provided in the shareholders agreement for protecting PE investors are (i) information rights, including rights to inspection and reporting obligations of investee companies (ii) management rights in terms of board representation, rights in respect of selection of and veto rights to ensure that certain critical decisions cannot be taken without consent of the investor and (iii) exit rights and restrictions on sale of shares, which can be in the nature of pre-emptive rights, put / call options, tag and drag rights.
These veto rights in the case of listed companies have often become controversial as they raise issues relating to control under the SEBI (Substantial Acquisition of Shares and Takeover) Regulations, 1997. On the other hand, enforceability of pre-emptive rights and put/ call options have become suspect on account of the issues mentioned earlier. The issue of options has also become controversial in case of private limited companies as pursuant to the consolidated FDI Policy issued by the Department of Industrial Policy and Promotion, grant of such options in respect of shares / convertibles issued to non residents would result in such shares/ instruments lose their equity status and make them subject to guidelines applicable to external commercial borrowings.
Given the lack of clarity on legality of exit rights and restrictions on share transfer, private equity investors are going to be hard put to find legal positions which provide down side protection. This may make it more difficult for mid size companies to find private equity funding and also result in more hard-nosed bargaining on stronger and harsher exit rights such as drag rights. Hopefully the government will do a rethink on put and call options in FDI policy. One possible regulatory middle path can be to treat put / call options based on fixed IRR as ECB, while those based on fair market value can be considered as having retained their equity character.
In view of the above contradictions the uncertainty regarding enforceability of pre-emptive rights in shareholders contracts still lingers in case of public companies and would need to be finally settled by the Supreme Court. However the legality and usefulness of such rights in case of private limited companies is fully recognized and well established. These preemptory rights form an essential andintegral set of rights available to the shareholders of a private limited company. The concept of these rights must be appreciated as a effective tool for ensuring the company character and yet preserving private nature of the business association which essentially has been created by the members with the intention of doing business with less technicalities and in a close association of less number of people. Though this concept overlaps with certain characteristics of a partnership, but still for reasons discussed above it maintains a distinct character than a firm and provides better encouragement to people interested in doing business to their competence of understanding and not being either highly well versed to handle affairs of a public company or interested in becoming mute investors therein. Thus it encourages people to do business. And nothing else but ‘encouraging business’ is ultimate motive of all commercial laws. Here lies the reason, motive, object and jurisprudence of preemptive rights of the shareholders of a private company. Logical analysis thus shows that the importance of legal protection of these preemptive rights of shareholders of a private limited company is as important as the legal recognition of ‘private limited company’ form of business association.
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