While shareholders agreement provides protection to the investors, there are limitations to the extent to which the investors can use this to compensate for the loss suffered especially when the transaction is vitiated by fraud.
The increasing incidents of shareholders’ value being eroded by corporate fraud have made it a significant risk for investors and shareholders. In India, in recent times, the risk of fraud has extended beyond matters internal to companies and has become entangled with unimaginable levels of corruption in political and public offices. In such situations, while retail shareholders are often left grappling with limited remedies, institutional and strategic shareholders find themselves going back to investment and shareholders’ agreements to evaluate the recourse available to them under these documents.
Investment and shareholders agreements are essentially private contracts and continue to be governed by the law of contracts. Therefore, frauds can have two impacts in respect of such contracts. Firstly, the contract itself can be vitiated by fraud and therefore may affect the manner and extent to which it is to be operative, which is the moot point in legal proceedings between the Telenor and Unitech groups and have arisen principally out of cancellation by the Supreme Court of UASL granted to 122 companies, including Uninor. The other aspects of investment/ shareholder’s agreement relevant to corporate frauds are the rights and remedies available to shareholders under such agreement in case they are confronted with the nightmare of dealing with a corporate fraud.
Fraud takes place where one conceals a material fact or suggests a fact which does not himself believe to be true with the intention of obtaining the consent of the other party. At the outset, it may therefore be cautioned that fraud requires the active knowledge of the person perpetuating it that the state of affairs which exists is different from what is being represented. This is, therefore, different from innocent misrepresentation, where the person making the misrepresentation labours under the belief that it is correct and represents the actual state of affairs. Under the Indian law, while civil consequences of fraud cannot be avoided on account of deemed knowledge or duty of due diligence of the other party, these are available as defences against action for misrepresentation.
DISCOVERY OF FRAUD AND REMEDIES AVAILABLE TO A FOREIGN INVESTOR
Terminating or rescinding a contract for fraudulent misrepresentation is generally recognized as a serious but a difficult matter. The problem is to be able to establish that the representation (unless it was a continuing one) was in fact fraudulent at the time when it was made. The next problem is the claim period. Contracts do stipulate a time period beyond which R&W claims cannot be brought against the party making representations. The period is indicative of the level of vigilance and diligence that the party must exercise to test the validity of the representations.
In my opinion, termination is not the best option. The better course would be to reserve all rights but be a privy to all information that the enterprise generates in its endeavour to repel the various acquisitions. Cutting off the relationship would necessarily mean cutting off all the information supply.
Free consent is an essential ingredient of a contract. A look at section 14 of the Indian Contract Act (“Contract Act”) reveals thatconsent cannot be said to be free if it is obtained by fraud.
A party which has been induced to enter into a contract is therefore, entitled under Section 29 of the Contract Act to either rescind the contract and seek damages or insist on the performance of the agreement and for compensation to ensure that it is put in the same position as it would have been if the representations were true and correct.
However, rescission of the contract is possible only when each party can be reverted to the position which they were prior to the contract. Therefore, in cases, where shareholders have, pursuant to the contract, taken measures which make it impossible to revert to the original position, for example, even where the party which has perpetuated the fraud, has relying on the contract created further third party rights or obligations, the party suffering the fraud would not be entitled to rescind thecontract, unless it can absolve the defrauding party of such third party rights and obligations. This can be a significant issue particularly in joint ventures or technical collaborations, where a defrauding party may have, based on the joint venture agreement, contracted furtherobligations, such as for supply of products and goods or for undertaking projects. By way of an illustration, in a situation where a joint venture partner who has brought technical expertise on the basis of which the joint venture company has obtained a particular third party project (say for implementation of an infrastructure project for a third party), finds that such participation has been induced by the other joint venture partner through fraud, it may not be possible for the technical partner to rescind the joint venture / technical collaboration.
An interesting aspect of this appears in the Uninor case. Based on facts stated by the Company Law Board in the case of Telenor Asia Pvt. Limited v. Unitech Wireless (Tamil Nadu) Pvt. Limited and Ors, it appears that the representations based on which Telenor has alleged fraud and for which it seeks to rescind the Shareholders Agreement, have been made by the Indian Strategic Partners (i.e. the Unitech Group) in the Share Subscription Agreements, by virtue of which Telenor became a majority shareholder. The Shareholder’s Agreement, which is sought to be rescinded, has apparently been entered into relying on the representations provided in the share subscription agreement. However, the Telenor group has sought to rescind only the shareholders agreement, where special rights have been granted to the minority Unitech Group and not the share subscription agreement. One possible reason for this may well be on account of the fact that restitution of parties may not be possible in so far as the transaction of share subscription is concerned. The claim therefore, creates an interesting disjunction between what are usually seen as conjoint rights i.e. the right to subscribe and the rights conferred as a shareholder.
In respect of contracts where restitution is not possible, damages and indemnity provide the only remedy. However, in cases of fraud, the challenge may often be to crystallise the damages, particularly where the financial impact of the fraud may not be clearly quantifiable.
WETHER SSA AND SHA ARE SEPARATE AGREEMENTS
The argument that the SSA and SHA are distinct and separate agreements is difficult to sustain when action under one leads to obligations under the other.The SHA is only a downstream consequence of the SSA and a fraud perpetrated at the inception of the transaction in the SSA must on first principles impact the SHA. Second, very rarely are such documents drafted without incorporating one in the other by reference especially in the completion and warranty clauses. For instance, if the purchaser has acquired shares that the seller did not have the ability to sell, would an SHA still survive?
MEASURE FOR QUANTIFYING DAMAGES WHERE FINANCIAL IMPACT OF FRAUD IS DIFFICULT TO DETERMINE
Taking the Telenor case as an example, the license was cancelled because a fraud was allegedly perpetrated. Any incremental cost that Telenor may bear to reacquire these licenses would be recoverable as damages. Of course, this leaves open the argument (which Unitech may well make) that the new proposed spectrum pricing is based on a new “per subscriber” principle and that could have occurred regardless of the fraud. In short, Unitech can argue that the incremental cost is a result of political force majeure and not a contractual breach so no damages are payable.
The other aspect of shareholders agreement is the ability of shareholders to use its provisions for dealing with a corporate fraud which occurs subsequent to the agreement. One of the most critical rights in dealing with corporate fraud is the information rights, which are typically found in shareholders agreements. The right to undertake independent audit or special audit is a critical tool available to investors and shareholders in unearthing financial indiscipline or worse in the company. The importance of this was underscored in the legal proceedings initiated by investors before the Delhi High Court in respect of Lilliput Kidswear Limited, where a significant tussle between the promoters and the investors centred on the conduct of an independent audit of the company.
Also fraud often gives the shareholders a right to terminate the contract and to exercise other rights arising out of such termination, for example changing the constitution of the board of the company, buy out of shares of the shareholder in management at a discount or a put or drag option. While the enforceability of some of these remedies, particularly a put option are still being tested in the judicial arena, clearly shareholders agreement continue to provide ammunition for shareholders seeking restoration to what they were entitled to.
In the recent years, there have been many instances of shareholders’ wealth being lost due to corporate fraud and political corruption which significantly impacts the manner in which companies are doing business in India. The Indian entrepreneur was earlier seen as succeeding “in spite” of the political system, but the unholy nexus between the entrepreneurial and the political class, which has emerged in recent cases of fraud and corruption, has dented the Indian entrepreneur’s image significantly. While shareholders agreement provide protection to institutional investors, there are limitations to the extent to which investors can use these to deal with erring management, and any such action cannot totally compensate for the loss suffered by shareholders. As India faces the real risk of falling out of the ‘BRIC wall’, probity in corporate dealings and a significantly higher amount of consistency and transparency in interaction of the political system with the economic class would certainly provide great cheer and confidence to investors who are not yet willing to write India off.
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