What a shareholders' agreement has to say to survive an Indian court

Section 5(1) states the shortest version of the point: the articles of a company shall contain the regulations for management of the company. Section 10(1) gives those regulations their force. When registered, the memorandum and articles bind the company and the members to the same extent as if they had been signed by the company and by each member, and the monies payable by any member to the company under them are a debt due from him to the company.

The articles are therefore the only place where a restriction on the company's own conduct has effect against the company. A clause requiring the affirmative vote of a particular shareholder is a covenant between the shareholders, and the shareholder who breaks it owes damages to the other shareholders. A clause requiring the affirmative vote of a particular shareholder for the company to do something is effective only if it is in the articles or in a resolution the company is obliged by its articles to pass. The two clauses look identical on the page and have different consequences.

Section 14 sets the cost of getting the articles wrong. A company may, by a special resolution, alter its articles, and every alteration and a printed copy of the altered articles must be filed with the Registrar, together with a copy of the order of the Central Government approving the alteration where the alteration converts a public company into a private company, within a period of fifteen days in the prescribed manner. The consequence of the filing requirement is that the articles are a public record, and the agreement that they mirror should be treated as public too.

There is a second reason to keep them aligned. Section 117(1) requires a copy of every resolution or any agreement in respect of the matters specified in sub-section (3) to be filed with the Registrar within thirty days of the passing or making of it, and the first proviso to that sub-section requires the copy of every agreement referred to in sub-section (3) to be embodied in or annexed to every copy of the articles issued after the agreement was made. An agreement that is filed and an article that contradicts it is a defect the company has to answer for, and the file is where a shareholder's lawyer will look.

The starting point is the size and shape of the board, and section 161(1) is where the appointment power begins. The articles may confer on the board the power to appoint any person, other than a person who fails to get appointed as a director in a general meeting, as an additional director at any time, who holds office up to the date of the next annual general meeting or the last date on which the annual general meeting should have been held, whichever is earlier. Section 161(2) allows the board, if so authorised by its articles or by a resolution passed by the company in general meeting, to appoint an alternate director for a director during his absence for a period of not less than three months from India, with the provisos that no person may be appointed as an alternate director for an independent director unless he is qualified to be an independent director, and that an alternate director must not hold office longer than the director in whose place he is appointed and must vacate the office if and when that director returns to India.

The nominee director is a different appointment. Section 161(3) provides that, subject to the articles of a company, the board may appoint any person as a director nominated by any institution in pursuance of the provisions of any law for the time being in force or of any agreement, or by the Central Government or the State Government by virtue of its shareholding in a government company. So the power to appoint a nominee director depends on the articles, which is exactly why the agreement has to be mirrored. A nominee who is appointed by the agreement alone, and not by the board under the articles, is not a director of the company.

Reserved matters then build on that. The clause that matters most is the one that requires the affirmative vote of a named shareholder, and it has to be in the articles to bind the company. The second is the one that requires the company's own organs to act only after a threshold is met, such as a capital commitment above a figure, which again belongs in the articles if the company is to be bound. The third is the procedure: who calls the meeting, what notice is given, in what form the consent is recorded, and what happens when the consent is withheld. A reserved matter without a procedure is a statement of intention, and a company can comply with it by getting the resolution passed in the meeting and minuting it.

The rule about how the affirmation is recorded is the one that is most often ignored. A shareholder who is required to give his consent has to give it in a form that is capable of being checked later, and the clause should say what form that is. It should also say what happens if the shareholder does not respond, because a consent requirement without a consequence for silence either gives the shareholder a veto that the company cannot use, or is ignored in practice.

A transfer restriction in the agreement binds the parties who signed it, because it is a contractual covenant against dealing with the shares. It does not bind the company, and it does not bind a transferee who takes without notice of it, and the agreement cannot do that without the articles. Section 161(3) is a reminder of the point from the other side: the nominee director is appointed by the board in the exercise of the power the articles confer, and the agreement is one of the sources that power may be traced to, but the board's act under the articles is what makes the appointment good.

The right of first refusal is drafted as a sequence with a price mechanism, and the drafting is where the value is. The clause has to say who offers first, in what form the offer is made, what information goes with it, how the offer is to be responded to, and on what terms the transferee may sell if the right is declined. It also has to say how the price is fixed. If the price is a formula, the formula has to be workable, and it usually has to say which accounts are used and who appoints the accountant. If the price is a valuation by a registered valuer, section 247 supplies the statutory framework: where a valuation is required to be made in respect of any property, stocks, shares, debentures, securities or goodwill or any other assets, or the net worth of a company or its liabilities, under the Act, it is to be valued by a person having the prescribed qualifications and experience, registered as a valuer, and appointed by the audit committee or in its absence by the board of directors of that company, and the valuer must make an impartial, true and fair valuation, exercise due diligence, and not undertake the valuation of assets in which he has a direct or indirect interest during the three years before his appointment or the three years after the valuation.

The price point in section 247 is worth noting for a family agreement. A valuer who has an interest in the company cannot value it, and the exclusion runs for three years before the appointment and three years after the valuation. In a shareholders' agreement where the founder is also the buyer under the right of first refusal, an arrangement that leaves the founder to value his own shares is not defensible, and the statutory rule gives the other shareholders an answer that does not depend on the agreement at all.

The notice periods and the treatment of a transfer that breaches the agreement are the other half. The agreement should say what happens to a purported transfer that ignores the right of first refusal, and whether the company is to be asked to treat the transferee as a shareholder. Section 88 requires the company to maintain a register of members, and the register follows the documents, so an unregistered transfer leaves the register and the agreement out of step with each other.

The two clauses work in opposite directions and they are not mirror images. A tag along right protects a minority shareholder who wants to sell: the clause obliges the selling shareholder to procure that the purchaser also buys the minority's shares on the same terms. A drag obliges a minority shareholder to sell when the majority sells. The drag is the more dangerous clause, because it forces the minority into a sale it did not choose.

The statutory routes are the benchmark for what the drag is trying to do. Section 235 gives the transferee company a right to acquire the shares of a dissenting shareholder where holders of not less than nine-tenths in value of the shares whose transfer is involved have approved the scheme within four months of the offer, and the transferee must then acquire the dissenting shareholder's shares on the terms on which the approving shareholders' shares are to be transferred, unless the shareholder applies to the Tribunal within one month and the Tribunal orders otherwise. Section 236 gives a route outside any scheme: once an acquirer holds ninety per cent. or more of the issued equity share capital, or any person or group becomes a majority or holds ninety per cent. by virtue of an amalgamation, share exchange, conversion of securities or for any other reason, that acquirer must notify the company of the intention to buy the remaining equity shares and offer to the minority at a price determined on the basis of valuation by a registered valuer, and the minority shareholders have the mirror right to offer to purchase the majority holding at the same prescribed price.

A drag clause drafted wider than those routes will be resisted, because the shareholder who is forced out of the company has no statutory protection and has only a contractual claim. The safer drafting is to make the drag operate only where the statutory conditions are satisfied, or to make the price payable to a dragged shareholder the same price that the statutory route would require, so that the shareholder can compare the two. Section 238 is the discipline that applies to the offer side of the route: the circular must be registered with the Registrar before it is issued, and it must contain a statement by or on behalf of the transferee company disclosing the steps it has taken to ensure that necessary cash will be available.

The share capital underneath the clauses has its own rules. Section 61(1) allows a limited company having a share capital, if so authorised by its articles, to alter its memorandum in general meeting to increase its authorised share capital, to consolidate and divide its share capital into shares of a larger amount, to convert fully paid-up shares into stock and reconvert them, to sub-divide shares and to cancel shares that have not been taken or agreed to be taken. The proviso to clause (b) is the one that matters in a shareholders' agreement: no consolidation and division which results in changes in the voting percentage of shareholders takes effect unless the Tribunal approves it on an application made in the prescribed manner. Section 62(1) governs the further issue of shares, which are offered to the existing equity shareholders in proportion, as nearly as circumstances admit, to the paid-up share capital on their shares, by a letter of offer limiting a time not being less than fifteen days and not exceeding thirty days within which the offer, if not accepted, is deemed to have been declined.

Deadlock is a contractual problem before it is a judicial one, and the ladder has to be written down while the parties are still able to agree. The first rung is escalation, with a named person on each side and a time limit. The second is a mediation route. The Mediation Act, 2023 created a pre-institution route and gave mediated settlements a defined standing, and it is a route a shareholders' agreement can point to, but the corpus this practice runs on does not carry the Act, so the procedure is not set out here and the clause should be drafted to work whether or not the mediation is completed within any particular period.

The third rung is the buy-sell, which has two forms. A put option makes one party the buyer of the other's shares on defined triggers, and a call option makes one party the seller. Both are contracts, and both need a price mechanism, a time for completion, and a provision for what happens if the buyer cannot pay. That last point is the one that is usually left out, and it is the one that decides whether the exit is real.

The fourth rung is the statutory route, and it is the one that does not depend on the other party's consent. A member who cannot be got out of the company, or a company run on a personal understanding that has broken down, can approach the National Company Law Tribunal under section 241 of the Companies Act, 2013, and the Tribunal may order the purchase of shares by other members or by the company, with the consequent reduction of capital, under section 242(2). The route is slow and it is adversarial, so it belongs at the bottom of the ladder. It is also the reason the ladder is worth having: the agreement can offer a quicker exit that both sides accept, because the alternative is the Tribunal.

A put or call involving a foreign shareholder raises the foreign exchange question, and that is outside this guide. The point to record is that a put option in an agreement with a non-resident is a financial transaction and has to be routed through the exchange controls rather than treated as a private arrangement between shareholders.

Section 27 of the Indian Contract Act, 1872 is the rule and it is short. Every agreement by which any one is restrained from exercising a lawful profession, trade or business of any kind is, to that extent, void. The first Exception saves an agreement by which one who sells the goodwill of a business agrees with the buyer to refrain from carrying on a similar business within specified local limits, so long as the buyer, or any person deriving title to the goodwill from him, carries on a like business therein, provided that such limits appear to the court reasonable, regard being had to the nature of the business.

The exception tells the drafter what a working restraint has to contain. It has to be a sale of goodwill rather than a share sale, the restraint has to be limited to specified local limits, and the limits have to be reasonable having regard to the nature of the business. A share sale with a non-compete is outside the exception on its own terms, and a founder who leaves the company and then starts a competing business will find the covenant unenforceable to the extent it restrains him.

That is why the drafting distinguishes the two periods. A restraint that operates during the term of the agreement is not the same as one that operates after it, and the indemnity and confidentiality clauses are drafted differently from the non-compete. Confidentiality is not a restraint of trade, because it restricts disclosure of information rather than the carrying on of a business, and a clause that protects the information rather than the market will survive. An exclusivity clause is a restraint, and it has to be tested against section 27 on the same footing.

The case that shows the drafting failure is Supervendence Company of India (P) Ltd. v. Krishan Murgai. The restrictive covenant in clause (10) of the service agreement was not enforceable against the respondent because the word leave in the clause referred to voluntary departure and not to termination of services by the employer. The Court said the appellant company should have taken care to use appropriate language while incorporating such a restrictive covenant so as to include every case of cessation of employment arising from any reason whatsoever and not used the expression leave, which normally is synonymous to the expression quit. The lesson for a shareholders' agreement is the same: the clause has to cover the case that actually happens, and a word used in the wrong sense decides the case.

Section 10 of the Indian Contract Act, 1872 is the starting point for every clause in the agreement. All agreements are contracts if they are made by the free consent of parties competent to contract, for a lawful consideration and with a lawful object, and are not thereby expressly declared to be void. The last clause matters here: nothing in section 10 affects any law in force in India by which any contract is required to be made in writing or in the presence of witnesses, or any law relating to the registration of documents, and that is the doorway to the stamp duty question.

An indemnity is a contract by which one party promises to save the other from loss caused to him by the conduct of the promisor or by the conduct of any other person. Section 125 gives the indemnified party the rights on which he may rely: he is entitled to recover from the promisor all damages he may be compelled to pay in any suit in respect of any matter to which the promise to indemnify applies, all costs he may be compelled to pay in any such suit if in bringing or defending it he did not contravene the orders of the promisor and acted as it would have been prudent for him to act in the absence of any contract of indemnity, or if the promisor authorised him to bring or defend the suit, and all sums he may have paid under the terms of any compromise of any such suit, if the compromise was not contrary to the orders of the promisor and was one which it would have been prudent for the promisee to make in the absence of any contract of indemnity, or if the promisor authorised him to compromise the suit. The words in the section are the drafting instruction: an indemnity that is not written in the terms of the section is a weaker instrument than the one the parties think they have.

A guarantee is a contract to perform the promise, or discharge the liability, of a third person in case of his default, and section 128 provides that the liability of the surety is co-extensive with that of the principal debtor unless it is otherwise provided by the contract. So a personal guarantee in a shareholders' agreement should state expressly what the surety's liability is, because the default position is that it follows the principal debtor exactly. Section 73 governs what a party can recover when the agreement is broken: compensation for any loss or damage caused by the breach which naturally arose in the usual course of things from the breach, or which the parties knew when they made the contract to be likely to result from the breach, but not for any remote and indirect loss. The Explanation requires that the means which existed of remedying the inconvenience caused by the non-performance of the contract be taken into account in estimating the loss, which is the drafting point: an agreement that says nothing about mitigation will be read with that rule.

Section 125 of the Contract Act and section 125 of the Companies Act are different sections with the same number, and so are sections 117 and 128 in each. The agreement has to be read with both sets, because a shareholders' agreement is a contract between the parties and, where it is filed and adopted, a document that governs the company.