Young India is turning entrepreneurial and with dozens of success stories of start-ups making it big, the age of entrepreneurship seems to have finally arrived. However, even a great and innovative idea, without adequate capital backing is not enough to set up a successful venture. Fund raising is a highly challenging task for any enterprise, especially a startup. With little to offer the traditional lenders in terms of hard assets, past performance and market value, most startups turn to private and professional investors for investments.
These investors provide capital for an agreed return and to secure the same generally acquire a stake in the company. They also insist upon having certain rights as a stakeholder in the decision making of the company to protect their interest. The agreed mechanism of investment, rights and obligations of the parties (both promoters and investors) are all formalized and captured in a set of transaction documents. These documents generally include Term Sheet, Shareholders Agreement and Share Transfer/Purchase Agreement (the "Transaction Documents").
Most professional and serial private investors understand the importance of documentation in securing their rights and insist on execution of the Transaction Documents. However, they often miss an important step in protecting their rights under the Transaction Documents by reflecting the same, especially their rights under the Shareholder's Agreement ("SHA") in the Articles of Association (the "AoA") of the company. The purpose of the SHA is to set out the internal management framework of the company that effectively protects the overall interest of the company as well as that of the shareholders, especially the investors. While, the Transaction Documents are essentially a private arrangement and bind only the parties to it, the AoA together with the Memorandum of Association ("MoA") comprises the constitutional documents of a company recognised by the applicable law. It regulates the internal management of the company, rights of the shareholders and the powers of its officers. Often, the SHA and the AoA have conflicting provisions and in this scenario the provisions of AoA have an overriding effect. This position has been upheld and reiterated through numerous pronouncements of the Indian courts over the years. Some of them are discussed below.
In V.B. Rangaraj v. V.B. Gopalakrishnan and others1, the question that fell for consideration before the Hon'ble Supreme Court of India ("SC") was whether the shareholders of a company can enter into an agreement that is contrary to or inconsistent with the AoA of the company. It was held by the SC that the SHA restrictions contrary to the provisions of the AoA would not be binding on either the shareholder or the company.
In World Phone India Pvt. Ltd. and Ors. Vs. WPI Group Inc., USA2, the shareholders of the company entered into a SHA wherein affirmative rights were granted to the shareholders. However, the same was not expressly averred in the AoA. The High Court of Delhi held that since the AoA was silent on the existence of an affirmative vote, it would not be possible to hold the provision as being binding on the company and its shareholders.
Similarly in the case of Akshya Ispat Udyog Pvt. Ltd. and Ors. Vs. Ishwardas Rasiwasia Agrawal and Ors3, the AoA of the company was not amended to incorporate the arbitration clause mentioned as the preferred method of dispute resolution in the document entered into between the parties. Consequently, it was held that arbitration could not be availed by the parties as the AoA was silent on this aspect.
The Supreme Court's observations in the case of Vodafone International Holdings BV Versus Union of India & anr4, further clarified the stance of the courts on the issue of conflicting provisions in a SHA and the AoA. It was stated that the restrictions imposed under SHA provisions, though in compliance with the applicable laws, are to be enforceable only when incorporated in the AoA.
From the above rulings it is amply clear that the AoA is given priority over the SHA and that the SHA cannot go beyond the AoA. It is thus crucial to duly incorporate the relevant provisions of the Transaction Documents in the AoA and make them an integral part of the company's charter document so that they have the legal sanctity for enforcement in case of inter-se disputes.
Footnotes
[1] AIR 1992 SC 453
[2] [2013] 178 Comp Cas 173 (Del)
[3] C.A. No. 328 of 2013 in O.P. No. 117 of 2013
[4] (2012) 6 SCC 613
Originally published April 12, 2017
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