To Compel or not Compel, Moving the Debate of Mandatory Shareholder Arbitration to India

Introduction

As the year nears its end, an article in Business Insider declares that the “funding winter” is approaching¹. The slowdown of the investment rush shifts our focus from the incoming investors to the existing shareholders.

In India, the shareholders’ agreement (SHA) is the foundational document determining the relationship between a company and its shareholders. After the execution of the SHA, a company is required to amend its articles of association (Articles) to bind the company to the obligations of the respective SHA. Today, in most (if not all) transactions, the arbitration clause is an integral part of the SHA and incorporated in the amended Articles.

At the onset, we must understand that a company is owned by its shareholders, however, it is represented by the Board. A cornerstone principle of arbitration is the explicit consent and submission of parties to arbitration.² In the event of a dispute, even though the parties are bound to arbitrate, the reference to arbitration is put up for a vote before the Board and the shareholders in their respective meetings. A resolution for submission to arbitration and appointment of arbitrator(s) is to be passed by a majority vote to initiate arbitration. This demonstrates that even if there is a “mandatory” arbitration clause, the shareholders and/or the Board may choose not to opt for it. In essence, a company cannot force a shareholder to submit to arbitration but to vote upon it.

Arbitration and shareholder disputes

The shareholder gains when the company gains. It is beneficial for a shareholder to opt for arbitration, even against the company because it helps prevent adverse publicity. Arbitration helps retain growth and creation of a company’s value even when disputes arise between the shareholder and the company.

A shareholders’ dispute may be:

Between two shareholders

All shareholders are contractually obligated to one another based on the rights encapsulated in the SHA (or other related documents such as a deed of adherence). As long as the SHA contains an arbitration clause, all parties are bound by it.

Between the company and the shareholder

Enforcing a right to arbitrate against the company requires the clause to be amended in the Articles. The courts in India have established that the company is only bound by the clauses of the SHA if they are amended in the Articles.³

A less frequent but equally likely dispute between a shareholder and company may be that of oppression and mismanagement. The Indian courts have clearly held that cases of oppression and mismanagement are not arbitrable.⁴

Between the shareholder and a third party

A principle of arbitration is that a non-signatory cannot be bound by an arbitration agreement. This brings us to the peculiar case of derivative actions by shareholders under arbitration. The earlier view was that only the management of a company could seek to enforce an arbitration clause and a single shareholder could not maintain such an action.⁵ A differing opinion was considered in Rashmi Mehra v. EAC Trading Ltd.⁶ It expounded an exception to this general rule.

“It is founded on the basis that the company being managed by miscreant directors or shareholders will not institute proceedings for protecting or enforcing the rights of the company. The person filing the derivative action must show that the company has the right to sue but will not do so on account of it being managed by miscreant directors. The defining characteristic of a derivative action suit is that it must be proved to be for the benefit of the company and not the individual shareholder.”

It is an especially important tool in the hands of the minority shareholders where the majority votes to not invoke arbitration. They may, through their respective nominee director, invoke such an issue with an Arbitral Tribunal. The action cannot be restrained by an injunction and the maintainability of the derivative action may be decided by the Tribunal.⁷

The Indian landscape

The Companies Act, 2013⁸, with the view to protect shareholder interests, provides for class action lawsuits under Section 245⁹. The Act, in addition to having an overriding effect over any contradicting provisions in the articles, has established the National Company Law Tribunal (NCLT) to redress any grievances of the shareholders. While Indian corporate law has endeavoured to provide a stable legal framework for shareholders, at the same time, since the enactment of the Companies Act, there have been no major class action lawsuits as of date. The same can be attributed to various aspects of costs and time consumption in litigation that have not been favourable to the shareholders.

A certain deterring factor, however, may be the securities laws of India.¹⁰ It is pertinent to note that the Securities and Exchange Board of India Act, 1992¹¹ was made to protect public interests and serve public functions. The adjudication, therefore, is reserved exclusively for the Securities and Exchange Board of India (SEBI) otherwise it may be contrary to public policy to allow for arbitration. This explains the stringency of law captured under the Act and the rules thereof.

Best practices across the globe

England and Wales

While arbitration clauses provide recourse in claims against other shareholders where a contractual remedy is sought, to obtain specific statutory remedies, particularly in unfair prejudice claims, the shareholders will still need to approach the English courts. The arbitrability of shareholder disputes being relatively novel, shareholders are provided with some protection within the meaning of Section 994 of the Companies Act, 2006¹² wherein, a shareholder can petition the court for relief in case a company’s affairs are being or have been conducted in a manner that causes unfair prejudice to the interests of the shareholder. While the English courts have considered the arbitrability of unfair prejudice claims,¹³the tribunal does not have wide power to grant all the available remedies under Section 994 such as a buy-out order. Therefore, going to court to seek an order for buy-out seems plausible amongst other options including derivative action under Sections 260-264 of the Companies Act, 2006 and a petition for just and equitable winding up under Section 122(1)(g) of the Insolvency Act, 1986.¹⁴

Brazil

Shareholder arbitration is encouraged under Article 109 of Law 6.404/76 (Lei das Sociedades Anônimas) which specifies that listed companies can include an arbitration clause in their articles.¹⁵ Para 3 clearly lays down that “any dispute between the shareholders and the corporation, or between the majority shareholders and the minority shareholders may be resolved by arbitration under the terms specified by it”.¹⁶ In fact, the São Paulo stock exchange Bolsa de Valores de São Paulo (Bovespa) established its own arbitration institution i.e. Câmara de Arbitragem do Mercado (CAM) for listed companies.¹⁷ Any company listed within the top two levels of the São Paulo stock exchange must agree to submit all disputes between the shareholders, the company and managers to arbitration with Bovespa.¹⁸

United States of America

In a nation like the United States, where class actions are commonplace, the corporate governance system is extremely shareholder centric. While the Securities and Exchange Commission resists shareholder arbitration, Section 2¹⁹ of the Federal Arbitration Act, 2014 concerning the validity, irrevocability and enforcement of the arbitration agreement does not prohibit it.²⁰ The United States Supreme Court has also demonstrated a pro-arbitration approach by placing arbitration agreements on an equal footing with other contracts²¹ and enunciating that “the statute would continue to serve both its remedial and deterrent function if the invoking party could effectively pursue its statutory cause of action in the arbitral forum”.²² Delaware is regarded as the most sophisticated jurisdiction where shareholder arbitration is concerned. The Delaware General Corporation Law provides for the use of arbitration, within the meaning of Section 102(b)(1) where a provision exists in the company’s articles; under Sections 109(a) and (b) where a provision initially exists or is added subsequently in the bylaws and also, where a provision is negotiated between shareholders and the company on individual basis.²³

Conclusion

The SHA and the articles should form the basis for regulating the arbitration of shareholder disputes. While the Securities and Exchange Board of India prescribes certain norms advancing arbitration in case of disputes between trading members and to redress investor grievances, so long as the rights affected are in personam or rights in personam derived from rights in rem, they would be referred to arbitration. Party autonomy being the cornerstone of arbitration in India, the enquiry must concentrate on whether or not the consent to arbitrate can be determined either expressly or by necessary implication and provisions must be drafted carefully so as to discern who is bound and what disputes are covered by the agreement.