Obligation to give an exit to dissenting shareholders

by Bhargavi Zaveri, Prateek Misra, Sumant Prashant, and Shefali Malhotra.

The Companies Act, 2013 (Act) obligates the promoters and majority shareholders of a listed company to buy-out dissenting shareholders, where the company has passed a special resolution:

1. amending the main objects for which the money was raised from the public¹; and
   
2. amending the terms of a contract referred to in the prospectus.²
   

The Act requires SEBI to frame regulations for the exercise of the exit right by the dissenting shareholders.³

On December 1, 2015, SEBI issued a discussion paper on this subject suggesting, amongst other things, the following amendments to the Act:

1. There must be certain thresholds which trigger the buy-out obligation imposed on promoters and majority shareholders. For instance, the buy-out obligation must be triggered only where the contract proposed to be amended affects the main line of business or revenue generation of the company, or where atleast a certain percentage of shareholders have specifically voted against the amendment.
   
2. Companies which have already utilised a certain threshold percentage of the public funds and companies with no identifiable promoters or majority shareholders, must be exempt from the provisions.
   

At NIPFP, we have written a response to this discussion paper. We recommend that SEBI should, as part of the ongoing process for the review of the Act, instead recommend the deletion of the provisions which impose a buy-out obligation on promoters and majority shareholders in the circumstances described above. Alternatively, the response recommends certain other thresholds for triggering this obligation, to give better effect to the legislative intent underlying these provisions.

This article summarises the reasons for recommending the deletion of these provisions from the Act and explains why there is no case for minority shareholder protection in the circumstances under which the Act imposes the buy-out obligation.

No market failure

State intervention in the form of obligating promoters and majority shareholders to buy shares of dissenting shareholders, cannot be traced to any market failure:

1. There is no information asymmetry amongst the shareholders who vote for and against a resolution that proposes to amend the main objects for which the money was raised from the public or the terms of a contract referred to in the prospectus. The company provides all shareholders with the same information when it supplements the special resolution with a notice explaining the reasons for the resolution.
   
2. The issue of market power is irrelevant where shareholders are voting on decisions of a company.
   
3. Shareholders approving or dissenting to certain resolutions of the company does not result in externalities.
   
4. There are no public goods involved when making decisions in relation to the affairs of a company.

Contradicts the concept of equity capital

A right to be given an exit in a listed company contradicts the risk-bearing nature of equity. Where a person acquires the shares of a company, he is entitled to:

1. the residual profits of the company, once the creditors have been paid;
   
2. participate in the decisions of the company, by exercising voting rights attached to his shares; and
   
3. sell his shares in the capital market.
   

The risk that the company may change the terms of its functioning, is factored in the price at which the investor acquired the shares. Guaranteeing an exit to equity holders on the ground of changes to the functioning of the company, is antithetic to the concept of equity.

Equity is a contract

The relationship between a company, its owners and management is essentially a contract. The terms of the contract are codified in the Act. When an investor subscribes to equity shares, he subscribes to the term that the company will be bound by decisions taken by a certain majority.

Other difficulties with the provisions

1. An obligation to buy out shareholders dissenting to a certain resolution imposes unforseeable costs on the promoters and the majority shareholders. Every resolution will have some shareholders who vote for it, some who specifically vote against it and others who do not vote at all. It is not possible to identify in advance the number of shareholders who will vote against the resolution and the value of shares at that time. The provisions, thus, impose an un-ascertainable financial burden on promoters and majority shareholders.
   
2. The provision may incentivise opportunistic behavior on the part of shareholders, at the expense of the company. Therefore, even if the resolution is beneficial to the company, shareholders may choose to vote against it, in the hope that the resolution will go through even without their vote, and they will, as dissenting shareholders, be entitled to put their shares on promoters or majority shareholders.
   
3. The requirement of a special resolution to approve the amendment of a contract referred to in the prospectus followed by an obligation to buy-out dissenting shareholders, makes contracts expensive for the company as a whole.⁴
   

 

Is there a case for minority shareholder protection?

Notwithstanding the arguments set out above, several jurisidictions confer statutory protection on minority shareholders against certain corporate actions or actions by the majority. Generally speaking, the State intervenes (in the form of a statute) to protect the rights of minority shareholders in two sets of circumstances:

1. Oppression and mismanagement by the majority - Minority shareholders may seek judicial intervention to protect themselves and the company against oppression and mismanagement. Here, the minority shareholder must establish that the impugned action amounts to oppressing or unfairly prejudicing their interests. The intervention is not automatic under law.
   
2. Change in control - The U.K. and most EU members states have regulatory frameworks, which obligate the acquiror to make an open offer to purchase the shares of the minority shareholders at different thresholds, restrict the management from taking defensive measures in certain situations, etc. The U.S. has a limited regulatory framework governing takeovers, and most of the rules governing takeovers have evolved through jurisprudence.
   

These circumstances involve the principal-agent problem where the management or majority shareholders are uniquely positioned to adversely affect minority shareholders. For example, in cases of a potential tender offer, the management may fend off an offer not suitable to them but which otherwise enhances shareholder value.

Under the Act, the changes which trigger the buy-out obligation do not involve the principal-agent problem so as to warrant an automatic buy-out. First, a change in the main object of the company requires a super majority approval. Second, a change in the main objects or a contract referred to in the prospectus, does not necessarily involve situations which can be exploited by the management or majority shareholders to the detriment of the minority. If either of these situations result in oppression or mismanagement, the Act contains a statutory remedy which can be invoked by the shareholders of the company.⁵

Similar provisions in other jurisidictions

A review of the laws governing corporations in some common law jurisidictions reveals that while minority shareholders have appraisal rights across jurisdictions, the events which trigger these rights are largely in the nature of change in control, mergers and consolidations involving the company. Exceptions can, however, be found in the corporation statute of New Zealand, where the law provides for appraisal to minority shareholders who do not to vote for a special resolution.⁶

Moreover, appraisal statutes impose the buy-out obligation on the company (and not majority shareholders or promoters) to purchase the shares of the minority shareholders.

Conclusion

For these reasons, our response to the discussion paper on this subject recommends that the provisions of the Act mandating the majority shareholders and promoters to buy-out dissenting shareholders in the circumstances enumerated above, should be deleted. Alternatively, it recommends certain thresholds for triggering the buy-out obligation, which give better effect to the legislative intent.

Acknowledgements

The authors thank Somasekhar Sundaresan and Shubho Roy for useful discussions on the response to the Discussion Paper.

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1. Section 13 of the Act provides that a company, which has raised money from the public shall not change its objects for which it raised the money unless (a) a special resolution is passed by the company; and (b) the dissenting shareholders have been given an opportunity to exit by the promoters and shareholders in control, in accordance with regulations to be specified by SEBI. Back
2. Section 27(1) of the Act says that a company shall not, at any time, vary the terms of a contract referred to in the prospectus or objects for which the prospectus was issued, except by way of a special resolution. Section 27(2) states that the dissenting shareholders who have not agreed to the proposal to vary the terms of contracts or objects, shall be given an exit offer by promoters or controlling shareholders at such exit price, and in such manner and conditions as may be specified by SEBI. Back
3. Under the Companies Act, 1956, the central government had the power to direct the purchase of shares of dissenting shareholders who do not agree to a change in the memorandum of association of a company, if the central government so deemed fit. Back
4. The prospectus of a company generally refers to material agreements entered into by it, including joint venture agreements, agreements with key management personnel, key suppliers, etc. Back
5. Chapter XVI of the Act. Back
6. Companies Act, 1993. Back

The authors are researchers at the National Institute for Public Finance and Policy.