Delano Furtado explains shareholders rights and protecting their interests when pledging their shares in order to raise funds for their own group business.
The shareholder disputes between the Shapoorji Pallonji Group (SP Group) led by Cyrus Mistry and the Tata Group continue to make headlines and shape corporate law in India. The current legal tussle began when the SP Group (a long term minority shareholder in Tata Sons) decided to pledge a portion of its shareholding in Tata Sons Private Limited (Tata Sons) to raise funds for its own group business and to deal with the outcome of the ongoing pandemic. The Tata Group filed proceedings in court objecting to any further pledge or transfer of shares in Tata Sons by the SP Group. While a larger corporate battle between the two shareholder groups has been ongoing, the current proceedings in the Supreme Court bring out new legal issues relevant to financial and strategic investors, as well as shareholders and joint venture partners in India.
Legal Issues
A fundamental legal question that has arisen in this case, is whether the creation of a pledge (i.e. common form of security created over company shares in favour of a lender) of shares of Tata Sons in favour of a third party lender would constitute “transfer”? The common law jurisprudence is clear that shares are movable property and like any other movable property carry with it an intrinsic right of the shareholder to mortgage or pledge such shares for securing a loan, unless agreed otherwise contractually.
A pledge may act as a mode of transfer of voting rights without transfer of shares. A pledgee or the lender may contractually enjoy voting rights over such shares although there is no actual transfer of shares by execution of a share transfer deed.
However, fundamentally, all the rights and benefits attached to the shares otherwise remain with the pledgor or borrower. Therefore, from a legal perspective, it is only upon invocation or enforcement of the pledge that the pledgee becomes the beneficial owner of the pledged shares and no residuary interest in the pledged shares remains in the favour of the shareholder. Mere creation of encumbrance only creates an interest in the shares in favour of the pledgee and does not by itself completely transfer ownership of the shares from the pledgor to the pledgee. As per news reports, the Supreme Court in its preliminary observation stated that a pledge may not amount to a full transfer
but was indeed a limited transfer of shares. This observation and interpretation of the Hon’ble Supreme Court (though said to have been made orally) could open the door to similar challenges and more shareholder disputes.
While the Articles of Association of Tata Sons (as available on the website of the Ministry of Corporate Affairs) do not specifically restrain any member from creating an encumbrance on its shareholding, the articles do contain specific restrictions in relation to transfer of shares, typically referred to as Rights of First Refusal (ROFR) in shareholder agreements. Interestingly, certain judicial pronouncements have stated that a pledge may not have the effect of transfer, particularly if under the articles of the company, the company shares have to be offered first to the existing members and on their refusal to any outsider, whom directors would approve. In practice, courts have also upheld such ROFR rights of a shareholder and allowed shareholders to enforce such rights at the time of sale of pledged shares to a third party upon invocation of a pledge by the lender.
‘Squeeze out’ of minority shareholders – the Articles of Association (i.e. company bye-laws) of Tata Sons empower ‘Tata Sons Limited’ at any time to compel a transfer of ‘ordinary shares’ of any of the minority shareholders by passing a special resolution. The National Company Law Appellate Tribunal 2 Order (which has been currently stayed by the Supreme Court) had restrained the Tata Group from exercising its rights under the Articles against the SP Group. Minority squeeze out provisions under Indian company law require a shareholder to make an application to the National Company Law Tribunal (NCLT) for buying out minority shareholders wherein the NCLT is required to approve such an arrangement between shareholders after following due process.
Impact of the Supreme Court’s Decision and Outcome
Pledging of shares of investee companies by a shareholder is a common method adopted when looking to raise funds for corporate expansion or restructuring plans undertaken by such shareholder groups. Hence, such limitations on fund raising for corporate groups whose finances and revenues have been adversely impacted by the Covid-19 pandemic could be damaging. Shareholders typically negotiate their shareholder agreements to allow a shareholder to pledge their shares in the company subject to: (i) approval of the other shareholders; (ii) rights of first refusal for the other shareholders; and (iii) any other terms and conditions mutually agreed. It is possible that Tata Group’s concern emanates from a potential scenario where it may be forced to pay a higher value to purchase SP Group’s stake in Tata Sons, if such shares are being sold by SP Group’s lenders (i.e. upon invocation of pledge) to a third party investor prepared to pay a premium for the SP Group’s stake in Tata Sons.
While it is fair to expect other shareholders to impose restrictions on transferability of shares of a privately held company to protect their own interests in such company, a shareholder should be permitted to raise some level of liquidity against a pledge of its shareholding in times like these and for genuine corporate needs.
The Supreme Court has for now issued a status quo order regarding transfer and pledge of shares until the final hearing on 28 October 2020. The Supreme Court’s judgment could have far reaching implications for the rights of minority shareholders to pledge shares of their investee companies.
Going by media reports, it appears that the SP Group may be willing to offer its stake in Tata Sons to the Tata Group for sale in the event that it is unable to pledge its shareholding to raise funds for its own business. This outcome could be to Tata Group’s benefit. Whether the ensuing corporate tussle between the Tata Group and the SP Group will see the Supreme Court uphold the rights of a shareholder to pledge its shareholding or from being forced to sell out to the majority shareholder, remains to be seen.
While a carefully negotiated and drafted shareholders’ agreement can help a shareholder enforce its rights without the need for a long drawn out and expensive court process, some corporate battles such as this one, involving highly reputed shareholder groups and years of history, collaboration and relationships attached to them may favour an amicable resolution to the dispute keeping long term business interests in mind and relationships intact
