Protecting Shareholder Rights Through Articles Of Association In Layered Corporate Structures

In corporate transactions such as mergers and acquisition, joint ventures, private equity and venture capital investments, it is not uncommon to have a holding company structure (Holdco Structure), that is, where the investment is made in a holding company which holds one or more subsidiaries and wholly owned subsidiaries.

While parties (e.g., investors, promoters or joint venture partners) have a shareholders’ agreement which governs their inter-se rights vis-à-vis the company, in the Indian context, it is also common to incorporate certain important provisions (particularly, relating to transfer of securities and company management) from the SHA into the Articles of Association of the company.

Typically, provisions which relate to board composition, board and shareholders meetings, veto matters, further issue of shares, transfer of securities (such as lock-in, right of first refusal, right of first offer, tag along, drag along, call option, put option), event of default and consequences, etc. are incorporated into the AOA (Usual AOA Provisions).

The need to incorporate SHA provisions in the AOA arises from various judicial precedents. One of the reasons for such requirement is that an AOA is a public document and provides constructive notice, particularly, of the Usual AOA Provisions to third parties. If SHA provisions are not incorporated in the AOA, then third parties acting in good faith (with no knowledge of SHA) could have a better right as opposed to company’s shareholders, if the company had not followed the SHA requirements. Therefore, to protect the rights of shareholders against third parties, it becomes important to incorporate the SHA provisions in the AOA.

For a public company, contract between two or more persons in relation to transfer of securities is recognised by Companies Act, 2013. Notwithstanding this provision, the present practice is to incorporate the SHA provisions with respect to transfer of securities in the AOA, particularly, to provide constructive notice to third parties.

In a Holdco Structure, the concerned parties or investors or joint venture partners are shareholders or security holders in the HoldCo and not directly in the subsidiary or wholly owned subsidiaries. Usually, the SHA of HoldCo includes provisions that contemplate similar rights for investors or joint venture partners in its subsidiary. Therefore, while the SHA provisions are incorporated in HoldCo’s AOA (and it becomes public), an interesting question arises as to whether AOA of the SubCo should be amended and if yes, what provisions should be incorporated in SubCo’s AOA and how such rights in SubCo are exercised by HoldCo’s shareholders.

If the SubCo is not a WOS, that is, the SubCo also has other shareholders, there would most likely be another SHA with respect to the SubCo which will be incorporated in SubCo’s AOA. In such cases, the HoldCo’s SHA and AOA will need to provide the way in which rights and obligations will be exercised in respect of the SubCo.

If the SubCo is a WOS, the HoldCo would be the only beneficial shareholder. Therefore, there would be no separate SHA with respect to the SubCo. In such cases, there will be an SHA in relation to the HoldCo which is also incorporated in HoldCo’s AOA which is in public domain.

Therefore, to the extent provisions in HoldCo AOA pertain to the SubCo, they would also be in public domain.

Having said that, if SubCo’s AOA does not incorporate such provisions, and the SubCo acts contrary to the requirements of HoldCo’s SHA and AOA, then third parties acting in good faith could have a better right as opposed to HoldCo’s shareholders. To ensure that HoldCo’s shareholders have a better right against third parties, it is advisable to incorporate HoldCo’s SHA provisions in the SubCo’s AOA. For example, if an action by SubCo requires consent from HoldCo’s shareholders but is not reflected in SubCo’s AOA, and the SubCo proceeds without obtaining such consent, any third party dealing with SubCo may contend that they acted based on SubCo’s AOA and consent from HoldCo’s shareholders was not required.

As the HoldCo’s shareholders are not direct shareholders in SubCo, it needs to be assessed, which provision of HoldCo’s SHA should be incorporated in SubCo’s AOA and how the rights are exercised by HoldCo’s shareholders in SubCo. SubCo’s AOA could incorporate the Usual AOA Provisions and provide that the rights in SubCo will be exercised by HoldCo and/or the shareholders of HoldCo as may be agreed between the parties.

In conclusion, it would be prudent to incorporate the provisions of HoldCo’s SHA and AOA in SubCo’s AOA. Failing to incorporate governance-related provisions into SubCo’s AOA could leave HoldCo’s shareholders with limited recourse—such as claiming for damages for breach of SHA—and they may not be able to specifically enforce SHA provisions against third parties.

Bhavik Narsana is partner at Khaitan & Co.

Pragya Mishra is associate at Khaitan & Co.

Disclaimer: The views expressed here are those of the author, and do not necessarily represent the views of NDTV Profit or its editorial team.