[Shravasti and Varuni are students at Gujarat National Law University.]
In 2021, the Supreme Court of India stayed an order of the National Company Law Appellate Tribunal which ruled that omission of pre-emptive clause from articles of association (AOA) does not amount to oppression and mismanagement (O&M). The stance is still unresolved, but it is imperative to underline the statutory importance of this right and call for pre-emptive clauses to be a standard feature in AOAs. This is because, the omission of a pre-emptive clause is a step that undermines the rights of stakeholders, thus causing O&M.
Background
The right of pre-emption can be understood from the landmark case where the Supreme Court laid down that the company must give the first option to buy the available shares, to the existing shareholders. The pre-emptive clause under the AOA is intended to uphold the concept of restrictive transferability of shares of a private company, thus making it an essential clause. Section 241 of the Companies Act 2013 explains oppression as the affairs of the company being conducted in a prejudicial manner to any member of the company / public. Further, it refers to mismanagement as material changes in the company not in the interest of any class of shareholders.
The omission of a pre-emptive clause and oppression and mismanagement are intrinsically related. This is because, at first, the pre-emptive clause largely determines the shareholding power of members of a company. Second, the dynamic of shareholding power majorly influences the instances of O&M.
Initially, in 2012, the question of an allegation of O&M as a result of omission of pre-emptive clause from the AOA arose in the matter of Darius Rutton Kavasmaneck v. Gharda Chemicals Limited, where the Bombay High Court held it to be oppressive. Later, while deciding an appeal to the case apex court left the question unaddressed. Moreover in 2021, the Supreme Court of India in Niklesh Tirathdas Nihalani v. Shah Poddar Nihlani Organisers (Private) Limited, was again presented to ascertain the stance on the same question of law. However, the court did not definitively answer the question and has temporarily stayed the order in the matter.
There is an imperative need to assess this unresolved question from the perspective of O&M under Section 241 of the Companies Act 2013, as this essential clause can influence the rights of minority as well as majority shareholders.
Decoding Implications upon Omission of Preemptive Clause
The central rationale for not qualifying the omission of the preemptive clause as an act as O&M has been the application of the ‘majority rule’. This majority rule propounded in a landmark case aims to legitimize all actions undertaken by the majority. However, it is important to note the Indian stance clarified in ICICI v. Parasrampuria Synthetics Limited where it was held that the mechanical application of the majority rule would be futile as Section 241 refers to ‘any class of shareholders’. In our opinion, the omission of the pre-emptive clause has implications on the majority shareholder, minority shareholder, and vested statutory rights of the members.
Implications upon the majority shareholder
First, to analyze how it affects the majority shareholders, the amendment of an AOA though legal may still have the effect of altering the affairs of a company and prejudicially affecting the majority shareholders in a burdensome, harsh manner, thus resulting in O&M. In the case of Capricorn Oil Limited v. Ratan Mohan Sarda, the management group’s action of turning the majority into a minority by allotting shares without pre-emptively offering it to all the existing shareholders was considered to be oppressive. The apex court has also emphasized that the actions of the board of directors which maliciously turn the majority shareholder into a minority shareholder are oppressive. In retrospect, the absence of a preemptive clause within AOA enhances the probability of the majority shareholders losing their majority ownership.
Implications upon minority shareholder
Besides, it jeopardizes the interests of the minority shareholders as well. The removal of the right of preemption clause will not make it obligatory for the company to primarily offer the available shares to the existing shareholders. This right under the AOA safeguards the minority and removal of it will reduce the opportunity provided to the minority shareholders to increase their shareholdings, this, in turn, reduces their chance to acquire a stronger shareholding position. An omission of such kind facilitates or enables the majority to purchase the minority.
Section 236 of the Companies Act 2013 discusses the purchase of minority shareholders in the event of having acquired 90% of the shares. The section uses the word ‘shall’ indicating that the majority shareholders have to mandatorily offer to buy out the shares to the minority. Although, the provision does not compel the minority to sell the share at a fair value but the omission of the preemptive clause will definitely increase instances of purchase of minority shareholding.
Moreover, if a company benevolently intends to offer the shares of the company outside the members, the pre-emptive clause should not act as a hindrance that needs to be abrogated from the AOA. The shareholders within the company having refused the shares of the company will be open to purchase by the members outside of the company. The pre-emptive clause will only act essential to restrict the free flow of shares. Taking this away from the shareholders shall constitute a stringent violation of their vested rights.
Statutory implications
The right of pre-emption is also provided as a statutory right under Section 62 of the Companies Act 2013. As opined by the Supreme Court of India, statutory rights cannot be ousted by the provisions of the MOA or the AOA. Thus, the significance of the pre-emptive clause is enhanced.
However, in 1992, the apex court in the case of VB Rangaraj v. VB Gopalakrishnan, held that the only restriction on transferability of shares must be provided in the AOA. A restriction, which is not specified in the articles, is not binding either on the company or on the shareholders. Thus, the right of pre-emption should be included in the AOA and its omission should amount to oppressive towards any class of shareholders.
Conclusion – The Need to Decide the Undecided
Considering the analysis, the pre-emptive clause in the AOA plays a pivotal role in the management of the company and an omission of the same amounts to O&M. There is an urgent need for the judiciary to recognize this an act of O&M. The omission of said clause also tilts the power dynamic by shifting power in the hands of majority stakeholders and taking away a statutorily vested right from the minority shareholder. This also enables or makes it easier for the majority to completely buy out the minority shareholder. Moreover, even in an instance where the pre-emptive right is omitted by a resolution of shareholders, it has the potential to be oppressive. Thus, the Supreme Court of India must give a clearer stance on this position that is much needed in contemporary times.
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