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CONFLICT BETWEEN ARTICLES OF ASSOCIATION AND SHARE HOLDERS AGREEMENT- ANALYSING THE UNSETTLED POSITION OF LAW

INTRODUCTION

Company laws in the Indian jurisdiction have given huge importance to the charter or the constitutional documents of the company. Under the Companies Act, 2013[1], to obtain an incorporation certificate, a company shall register its Memorandum of Association and Articles of  Association.

India has one of the world’s fastest-growing economies, as a result, there has been an exponential growth in the number of fundraising transactions, especially in the start-up ecosystem in which, a Shareholders’ Agreement plays an important role.

Since a company is governed by its charter documents, there can be situations in which, the company’s contracts contradict the provisions of its charter documents. This blog describes contradictions in one of such contracts.

ARTICLES OF ASSOCIATION

Articles of Association (AOA) is one such mandatory charter document of a company that defines the way the company shall function, it can be called the company’s internal regulations or bye-laws, and it also frames the internal management of the company. The company can impose on itself restrictions in addition to the law of the land through its Articles which are binding on the company.  It is a public document and can be availed by the general public. Section 2(5) of the Companies Act, 2013 (the Act), defines ‘Articles’ as articles of association of a company originally framed or altered from time to time or applied by company law[2]. From this, we can understand that it can be altered by passing a special resolution in a general meeting[3] unless the articles themselves prescribe certain entrenchment provisions. According to Section 10 of the Act, it is a contract between each member and the company[4] as a result, once the company is registered, a member can seek redress for any act of the company that is contrary to its articles. As per the wording of Section 10, an AOA forms a contract only between the company and its members and not outsiders or any third person even if the articles give them certain rights[5]. It can be understood that any person who is not a member is an outsider, but in common law, it is interpreted as a member who is acting in the capacity of a member, which means that even a member can be an outsider[6] if such a right is in question which does not come with membership.

SHAREHOLDER’S AGREEMENT

A Shareholder’s Agreement is a private contract entered into between a company and its shareholders to protect the shareholders’ interests and investments A typical Shareholders Agreement would contain clauses regarding the rights and obligations and shareholders, management of day-to-day activities of the company, matters related to shares, protection of minority shareholders, veto powers, and others[7]. It is an optional document and a private contract, hence unlike AOA, it cannot be viewed by the general public. The Act has not clarified the position of the Shareholders Agreement but, the Act, states that the shares of a public company shall be freely transferable[8] and the proviso to which states that Provided that any contract or arrangement between two or more persons in respect of transfer of securities shall be enforceable as a contract[9] from which we can understand that the Act recognizes such contracts. These provisions are limited to public companies. Companies Act is silent about the usage of such contracts by private companies.

CONFLICT AND PRIMACY

The conflict between the two arises when one of them is not consistent with the other. The overriding clauses between the two are mainly about two matters, one related to share transfer rights and the other related to inter-se governance rights, such as affirmative voting rights, board of directors, and others[10]. Indian jurisprudence recognizes the transfer of shares as an inherent right that comes with the ownership[11] subject to reasonable restrictions, therefore any agreement which restricts the right to transfer the share is not binding. The only necessity is that it should be set out expressly.

The question which arises is where should it be stated? Which document shall govern the rights of a shareholder to transfer his shares? Which document will have primacy over others in case of contradictory provisions?

The Act is silent on these issues, but there are a series of judgment which has set forth the way this issue has to be treated.

In VB Rangaraj vs. VB Gopalakrishna[12], the Shareholder agreement imposed two restrictions, firstly a living shareholder can only sell his shares to an existing member and secondly, such member should be from the same branch of the family. However, the Articles did not impose any such restriction. The Supreme court opined that even if a clause is consistent with the Act, it would be binding only if it is consistent with the Articles. The agreement imposed additional restrictions which were not expressly mentioned in the Articles and hence were held not to be binding[13]. From this, it could be construed that Articles of Association have primacy over Shareholders Agreement and any restriction on transfer should be expressly mentioned in the Shareholders Agreement. The same position was upheld by the Supreme court for matters not involving the transfer of shares in IL & FS Trust Co. Ltd v. Birla Perucchini Ltd[14].

Confusion in law started to arise when the courts started to disregard the Rangaraj judgment without it being overruled. In Premier Hockey Development Private Ltd. v. Indian Hockey Federation[15], a clause in SHA was held to be binding which was not incorporated in the AOA only because it was consistent with the Act.

The same issue was dealt with in Vodafone International Holdings BV v. Union of India[16], in which the Supreme Court made three major observations: –

  1. a) That the Supreme Court does not agree with Rangaraj’s conclusion that restrictions in an SHA, while consistent with company law, are only authorized when they are incorporated into the Company’s articles but do not overrule the decision.
  2. b) Shareholders may enter into any arrangement in the best interests of the Company, provided that the provisions of the SHA do not contradict the articles of the Company.
  3. c) A breach of SHA that does not violate the Articles of a company is a valid corporate action, but the parties agreed to seek remedies under the general law of the land rather than the Companies Act.[17]

Further issues arise in World Phone India Private Limited and Ors vs. WPI Group Inc., USA[18], the Company Law Board held that a clause giving affirmative voting rights in SHA would be enforceable even though it is not incorporated in the AOA, but Delhi High Court on appeal overruled the decision and held that it would be unenforceable since it is not mentioned in the AOA. As per the Vodafone judgment, there has been a breach of SHA and the party can claim relief for breach of contract under the law of Contracts but not under the Companies Act.

The issue of articles being silent is not resolved yet. In the World Phone case, articles were silent on the issue of affirmative voting rights. Whereas, the Vodafone judgment only clarifies the position relating to the contradiction between the two hence imposing the Vodafone judgment on the given case would give rise to ambiguity.

CONCLUSION

The courts have been very dynamic about this issue, it is a well-settled law that AOA, being the fundamental constitutional document of a company, has primacy over the SHA, but there is a need for the courts to look into the matter where the Articles are silent. SHA plays a major role in various corporate transactions and India undergoing exponential growth in such transactions is likely to face similar litigations shortly.

Looking at the current position, it is advised that every provision of SHA must be incorporated into the AOA.

Authors Name: Vishnudath Varma (St. Xavier’s University, Kolkata) & Vishnurath Varma (JIS University, Kolkata )

 References:

[1] Companies Act, 2013

[2] Companies Act, 2013, s. 2(5)

[3] Companies Act, 2013, s. 14

[4] Borland’s Trustee v. Steel Bros & Co Ltd. (1901) 1 Ch 279

[5] Browne v. La Trinidad (1887) 37 Ch D 636

[6] Eley v. Positive Govt Security Life Assurance Co (1876) LR 1 Ex D 88

[7] ‘Shareholders Agreement versus Articles of Association’ (akm, 9 March 2017) <https://www.akmllp.com/edulaw/shareholders-agreement-versus-articles-of-association/ > accessed 23 January 2023

[8] Companies Act, 2013 s. 58

[9] Companies Act, 2013 s. 58 (2)

[10] Umakanth Varottil ‘Conflicts between Shareholders Agreement and Articles of a company’ (IndiaCorpLaw, 6 June 2013) < https://indiacorplaw.in/2013/06/conflicts-between-shareholders.html > accessed 24 January 2023

[11] Sidharrth Shankar, Vidur Prabakar, ‘Articles of Association v. Shareholders Agreement- The Conundrum’ (Mondaq, 4 November 2020) <https://www.mondaq.com/india/shareholders/1001432/articles-of-association-v-shareholders-agreement–the-conundrum > accessed 24 January 2023

[12] VB Rangaraj vs. VB Gopalakrishna (1992) 1 SCC 160

[13] Tripathi, Shivnath, ‘Shareholders Agreement and Articles of Association’ (SSRN, 17 April 2013) <https://ssrn.com/abstract=2280680> accessed 24 Januray 2023 

[14] IL & FS Trust Co. Ltd v. Birla Perucchini Ltd [2004] 121 Comp Case 335

[15] Premier Hockey Development Private Ltd. v. Indian Hockey Federation O.M.P. 92/2011

[16] Vodafone International Holdings BV v. Union of India (2012)

[17] Varottil (n 7)

[18] World Phone India Private Limited and Ors vs. WPI Group Inc., USA  (2013) 178 CompCas 173 (Del)