Navigating Exit Strategies: Enforcing Shareholders’ Agreement Clauses

Introduction:

Exit clauses in shareholders’ agreements (SHAs) play a crucial role in determining how and when investors or shareholders can exit a company, safeguarding their interests while ensuring the smooth functioning of corporate structures[1]. These clauses are very critical for start-ups or privately held companies where investors try to find an easy return and reduce risks. Some of the common exit mechanisms are a put option, drag-along rights, and tag-along rights. In this mechanism, there would be attaching some specific conditions for selling or transferring shares, such as during a merger or acquisition.

The enforceability of these exit clauses has gained increased significance with the rising corporate investments and complex shareholding structures in India. Relevantly, the forms that these clauses take are controlled through the regulatory  mechanism provided by the Companies Act, 2013, the Securities Contracts (Regulation) Act, 1956, and other key judicial precedents. However, several challenges persist, including ambiguities in public policy and contractual limitations. The right of enforcement of exit clauses, though, still remains an important constituent in long-term maintenance of investor confidence and the protection of interests of minority shareholders under the changing Indian corporate law.

Types of exit clauses in Shareholders Agreement and their enforcement:

Tag-Along Rights (TAR) and Drag-Along Rights (DAR):

Tag along rights and drag along rights are big contractual provisions in shareholders’ agreements, basically controlling transfers of equity share in companies. Therefore, tag along rights benefit the minority shareholders in being included in the sale carried out by majority shareholders so that they too exit on equal terms. Drag along rights give majority shareholders the power to make minority shareholders sell their shares if an incoming investor demands full control; otherwise, it creates smoother transactions.

The enforceability of these rights in India has evolved, particularly through key court rulings. The Supreme Court’s decision in Vodafone International Holdings BV v. Union of India[2] clarified that tag along and drag along rights are binding, regardless of their mention in a company’s Articles of Association (AoA), provided they do not contravene existing provisions. This stance contrasts with earlier judgments, like V.B. Rangaraj[3], which suggested such rights required incorporation in the AoA to be enforceable. Recent developments, including SEBI’s notifications[4], have further legitimized these rights, allowing them to exist independently as contractual arrangements, thus solidifying their role in shareholder agreements.

IPO Provisions:

An Initial Public Offering (IPO) refers to the process by which a previously unlisted firm offers its shares or convertible securities to the public for the first time. The firm, thus, can raise equity capital and enhances its credibility and opens up access to wider capital markets, and therefore grants shareholders ownership rights and allows them to exit the investments through the secondary market, making an IPO an attractive form of exit for the investors.

The enforceability of an IPO clause would primarily lie in the Shareholders’ Agreement, that outlines the company and its promoters’ obligations toward the IPO. The most critical terms are “best efforts” and “reasonable efforts,” which mean different things: “best efforts” involve attempting to do everything that could be done to raise funds through the IPO, whereas “reasonable efforts” demand at least one viable action. The burden of proof is different in disputes. In “best efforts,” the company has to prove that all reasonable measures have been undertaken; with “reasonable efforts,” the actions undertaken should be in consonance with the provisions of the SHA[5].

Careful negotiation of these terms is vital to align with investor timelines and expectations. While investors can seek advantages such as priority in share offerings, these provisions do not guarantee the enforceability of the IPO clause as an exit right, underscoring the importance of clarity in contractual terms.

Liquidation Preference[6]:

In merger or asset sales-type liquidation events, investors have preference over other shareholders in receiving proceeds. This clause ensures the investors get back their investment before other stakeholders. Statutory law appointment of a liquidator is not governed by liquidation preference arrangements in transaction documents. However, the company and its promoters may be under contractual obligation to follow the same provisions, giving rise to a cause of action for due performance on behalf of the investors. Liquidation preference clauses may further demand that promoters top up investors on any shortfall in proceeds, although such payments may also have tax implications.

In court, the overriding nature of the Insolvency and Bankruptcy Code (IBC) raises questions about the enforceability of these arrangements[7]. For holders of the same class of shares, proceeds must be distributed equally unless separate classes are created, as preferential treatment conflicts with section 53 of the IBC.Additionally, granting liquidation preference to foreign investors could be seen as providing an assured exit, potentially violating Reserve Bank of India regulations. Care must be taken to comply with pricing guidelines when structuring these clauses.

Sale to Third Party: 

The sale of securities to a third party is a common exit option for investors under a Shareholders’ Agreement (SHA), allowing existing shareholders to retain their shares. A strategic sale involves selling the entire share capital to a strategic acquirer, which may be challenging for promoters as it cedes control of the company. A trade sale typically involves selling most assets and the business to a third party, often identified by reputable merchant bankers.

To ensure enforceability, the SHA should specify the terms of the sale, including trigger events, price ranges, and conditions, to avoid ambiguity and potential internal conflicts among investors with differing exit timelines. The obligation to facilitate these exits should rest jointly on the company and promoters. Recommended clauses may include defining eligible purchasers, payment modes, settlement terms, and representations or warranties. Well-drafted clauses increase the likelihood of investors achieving specific performance as outlined in the SHA.

Call and Put Options:

A put option grants the buyer the right to sell an asset at a predetermined price, while the seller has the obligation to buy if the option is exercised. Put options are useful for hedging against potential losses and can generate profits when the underlying asset’s price declines. In India, in-the-money options are mandatorily exercised.

The enforceability of put options in private companies generally faces few concerns. Disputes may arise regarding the enforcement process, trigger conditions, and pricing calculations. Regulatory bodies like SEBI and RBI have scrutinized put options providing assured returns, labeling them as speculative and potentially illegal under the Securities Contracts (Regulation) Act. However, regulatory changes have allowed options in shareholder agreements, provided they meet specific conditions.

In contrast, call options allow buyers to purchase assets at a set price, also with similar enforceability considerations. Courts have upheld enforceable put options that lack guaranteed returns, emphasizing their protective nature rather than speculative intent.

Conclusion:

The enforceability of exit clauses in shareholders’ agreements (SHAs) is essential for investor confidence and effective corporate governance, particularly in India’s evolving startup landscape. Key mechanisms, including tag-along rights, drag-along rights, and IPO provisions, require precise drafting to address enforceability challenges.

The Singapore High Court’s[8] ruling favouring WestBridge Ventures highlights the significance of clearly defined exit clauses. The court upheld WestBridge’s rights to exit via buybacks or sales to third parties, including competitors, if the company did not facilitate these options. This judgment illustrates that SHAs governed by Singapore law can enable arbitration for disputes typically seen as non-arbitrable in India.

This landmark decision emphasizes the need for clarity in exit clauses, setting a crucial precedent for future legal disputes. Companies and investors must navigate these frameworks carefully to protect their interests and promote a stable, growth-oriented environment.

[1] Let’s Law. (n.d.) The investor exit clauses. Available at: https://letslaw.es/en/the-investor-exit-clauses/ (Accessed: 20 September 2024).

[2] Vodafone International Holdings BV v. Union of India, (2012) 6 SCC 613

[3]  V.B. Rangaraj v. V.B. Gopalkrishnan, (1992) 1 SCC 160

[4] Securities and Exchange Board of India (2013) Notification No. LAD-NRO/GN/2013-14/26/6667. Available at: https://www.sebi.gov.in/sebi_data/attachdocs/1380791858733.pdf (Accessed: 20 Sep 2024).

[5] Smt. Manika Seth v. Sett Iron Foundry, Arbitration Petition No. 80 of 2020 (Calcutta High Court)

[6] LegalWiz (n.d.) Key clauses to include in your shareholders agreement. Available at: https://www.legalwiz.in/blog/key-clauses-to-include-in-your-shareholders-agreement (Accessed: 20^th Se 20244).

[7]International Bar Association (IBA), 2021. Are liquidation preference arrangements legally enforceable in India? [online] Available at: https://www.ibanet.org/Are-liquidation-preference-arrangements-legally-enforceable-in-India [Accessed 21 September 2024].

[8] Inc42. (2024) ‘WestBridge, Anupam Mittal, Shaadi: The Dark Side of Shareholders Agreement’, Inc42. Available at: https://inc42.com/features/westbridge-anupam-mittal-shaadi-the-dark-side-of-shareholders-agreement/ (Accessed: 21 September 2024).

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