21 May 2015 19:33 IST

Why Shareholder’s Agreements are important

The Agreement puts in place rights and rules between the shareholders which are additional to the rules outlined in Company Law

In raising any round of investment, a crucial component is the ‘Shareholders Agreement’. In brief, it is a contract among stakeholders in a Company, and the Company is also usually made a Party to the Agreement.

Most people believe that a Shareholder’s Agreement outlines the rules of Company Law in respect of the shareholder’s rights vis-à-vis each other. This is not true.

The main goal of a Shareholder’s Agreement is to put in place rights and rules between the Shareholders which are additional to the rules outlined in Company Law. Naturally, none of the rules can be contravened, but to suggest that the rules are repeated in the Shareholder’s Agreement would make drafting the Agreement pointless.

Points usually covered in a Shareholder’s Agreement

A Shareholder’s Agreement provides for matters such as restrictions on transfer of shares (right of first refusal, right of first offer) the forced transfers of shares (tag-along rights, drag-along rights) and nomination clauses with respect to directors on the board veto rights available to certain kinds of shareholders.

Some flags to heed while drafting a Shareholder’s Agreement

The landmark decision in respect of Shareholder’s Agreements was by the Supreme Court, in V.B. Rangaraj v. V.B. Gopalakrishnan, [AIR 1992 SC 453], which is actually one of the few decisions rendered by any court in India on Shareholder’s Agreements. This decision of the Supreme Court held very significantly that the provisions of the Shareholder’s Agreements would be ineffective unless the provisions were also included in the Articles of Association of the Company. Although this rule has been slightly altered following the decision of the Bombay High Court in Messer Holdings Ltd vs. Shyam Madanmohan Ruia, a general tip which must be given to each entrepreneur / venture capitalist / fund looking at preparing its Shareholder’s Agreement is to also include as many of the clauses as possible within the Articles of Association of the business. This way, the chances of a Court enforcing the Agreement in case there is a litigation surrounding the terms increases.

The practice today is that while drafting Shareholder’s Agreements, most Venture Capitalists / funds (and in fact even entrepreneurs while drafting their own agreements between the founders) put in place sweeping clauses which Courts would not be so willing to enforce.

This is a synopsis and an introduction to Shareholder’s Agreements. Although every agreement is different, a general rule is that a certain degree of fairness and restraint pays, especially if the Agreement is eventually litigated in a Court of law. But for the reader interested in getting a deeper understanding of Shareholder’s Agreements, reading some of these judgments (and our subsequent contributions) might help:

1. Mafatlal Industries Ltd. v. Gujarat Gas Co. Ltd., [1999] 97 Comp. Cas. 301 (Gujarat High Court);

2. Smt. Pushpa Katoch v. Manu Maharani Hotels Ltd., [2006] 131 Comp. Cas. 42 (Delhi High Court);

3. Western Maharashtra Development Corpn. Ltd. v. Bajaj Auto Ltd, [2010] 154 Comp. Cas. 593 (Bombay High Court);

4. Messer Holdings Ltd v. Shyam Madanmohan Ruia, [2010] 159 Comp. Cas. 29 (Bombay High Court);

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