Author: Mr. Karan Kamath
Advocate, Bombay High Court & LLM Candidate (Commercial Law), University of Edinburgh
On August 9, 2021, the Securities Appellate Tribunal (“SAT”) delivered a split verdict on whether a company’s Articles of Association (“articles”) can prescribe conditions for issuance of shares, in addition to those prescribed in the Companies Act, 2013 (“Act”)? Here, PNB Housing Finance Limited’s (“PNBHF”) had planned to undertake a preferential allotment to some investors. After the commencement of voting on the resolution to approve the allotment, the Securities and Exchange Board of India (“SEBI”) restrained PNBHF from moving ahead with the process, unless a report from a registered valuer on pricing of the preferential allotment was obtained. SEBI was enforcing a provision in PNBHF’s Articles of Association that required that any preferential allotment must be at a price “determined by the valuation of a registered valuer”.
Before the SAT, the PNBHF relied on the Companies Act and secondary legislations to argue that the registered valuer requirement in its articles is not enforceable. The Act requires a registered valuer’s report subject to any other conditions that may prescribed. The requirement has been done away with, for listed companies, via the Companies (Share Capital and Debentures) Rules, 2014 (“SCDR”). However, the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018 (“ICDR”) now prescribe that the price cannot be lesser than the higher of the company stock’s volume weighted average prices during twenty-six and two weeks. According to PNBHF, the ICDR requirement was the sole binding rule.
Essentially, the SAT had to resolve an apparent contradiction between the company’s articles and ICDR. It delivered a split verdict, with its presiding officer ruling in PNBHF’s favour and the judicial member ruling otherwise. Nonetheless, the orders raise interesting questions on the mandatory nature of Indian company law and permissibility of ‘contracting over’ its rules.
I. Hierarchy of Norms
While mocking the then-recent innovation of a public corporation in their opera ‘Utopia, Limited’, Gilbert and Sullivan began describing a company as “some seven men form an association”. Although channelling the contemporary scepticism of limited liability, Gilbert and Sullivan accurately encapsulated the company concept as an association, a contractual arrangement between people. A company’s constitutional documents, including the articles, are a contract between its members. When a member sells their share to a third person, that third person purchases the share and accedes to the existing contractual arrangement. That contract, however, cannot contradict the Act, and can operate only to the extent it is not repugnant to the Act. For example, if the PNBHF’s articles said that the price of a preferential allotment must be less than the two prices as described in the ICDR requirement, then, the articles would be inoperable because they contradict the Act. However, the situation in PNBHF’s case was more complex. The two opinions in the SAT’s split verdict are two competing ideas on how the hierarchy of norms should play out.
The presiding officers’ opinion was that the articles were wholly repugnant to the ICDR. This was for two reasons. Firstly, that ICDR is a complete code in itself and the articles could not add extra conditions to what was prescribed therein. Secondly, if the articles were harmonised with ICDR, so as to allow PNBHF to follow both while undertaking a preferential allotment, then there would be ‘two’ rules for listed companies. Companies like PNBHF would have to follow their articles as well as ICDR, and companies without such a valuer-requirement would only have to follow ICDR.
Both these arguments seem to be unconvincing. Coming to the first reason, the term ‘complete code’ refers to exclusivity of a legislation over other legislations. In Girnar Traders v State of Maharashtra, a Constitutional Bench of the Supreme Court noted that the phrase cannot have any watertight definition, but can be instead described on the basis of certain parameters. The word ‘complete’ refers to a certain threshold of certainty, in such a manner that:
“[the code] has to be a compilation of provisions which would comprehensively deal with various aspects of the purpose sought to be achieved by that law and its dependence on other legislations is either absent or at best is minimal.” (Emphasis supplied)
Similarly, the parameters that have been held to be hallmarks of a ‘code’ ordinarily describe a statute’s relation with others. The articles of a company do not have the force of a statute, and cannot directly be impacted by the ICDR being a ‘complete code’.
Similar is the caution against having separate rules for companies with a valuation requirement in their articles. A shareholder’s rights contained in the articles are purely contractual and are in addition to the statutory rights provided by the Act. But the articles bind the company vis-à-vis the shareholders. There is nothing in the ICDR that expressly bars a valuer’s report as a pre-allotment requirement. The contractual right that arises from the articles cannot be ousted by the hierarchy of norms between the two regulations and the statute, unless, obviously, the ICDR expressly bars that right.
In the absence of statutory or regulatory force, freedom of contract can only be restricted on exclusionary grounds of public policy, however, that is not the case here. It is not apparent why having separate internal price discovery processes subject to the ICDR would be a public policy concern. In any case, the articles are a public document that acts as a notice of the contractual arrangement that the company is founded on to the prospective investors. As long as they know what they are dealing with, it does not matter if there are two, three, or more sets of rules overall. The valuer requirement is not the only additional requirement a company could add. For example, a company could contract in its articles to not preferentially allot shares unless they were valued 10% more than the price mandated by the ICDR. It would be absurd if the regulators nullified all such contractual arrangements other than by specifically ousting their effect in the ICDR.
On the other hand, the judicial member’s order obviously deems this a possible harmonious construction exercise. Both the articles and the ICDR can co-exist, as long as the valuer’s report concludes a price higher than what the statutory regulations demand. However, the judicial member does not explain the consequences of the contrary. This is an academic question which the SAT correctly did not address. But, consider a situation where the valuer’s report discloses a price lower than the Regulations. The articles stated that: preferential allotment can be made “to any persons … if the price of such shares is determined by the valuation of a registered valuer”. Obviously that allotment would be void according to the ICDR, however, allotting for a price other than that concluded by the valuer would also offend the articles. Resultantly, the articles can be said to contradict the law, and therefore, be void to that extent. The company could theoretically conform to the same procedure in the future as long as a price higher than that mandated by the ICDR is discerned.
II. Contracting Out and Over
Company law rules can be divided into two kinds: mandatory and default. As the name suggests, the former are set by the law and disallow any contractual deviation by corporate constituencies. The latter are a standby arrangement established by the law, which apply only if the corporate constitution fails to provide otherwise. The amount of each kind of rules differs congregating company law differs from jurisdiction to jurisdiction.
It is possible to contract out of default rules. For example, while issuing bonus shares, the Act grants the existing shareholders the right to renounce their bonus allotment in favour of a third person, but a company’s articles can strip its shareholders of that right. This is ‘contracting out’ of the default rule. It is tempting to see that no form of contracting is permissible as to a mandatory rule. But that is not the case. Interestingly, although companies cannot contract out of mandatory rules, they can ‘contract over’ them. For example, in Amruta Kaur Puri v Kapurthala Flour Oil and General Mills Company Pvt Ltd (cited in the judicial member’s opinion), the articles provided for a higher quorum for the board meetings than the statutory mandate. The Punjab and Haryana High Court upheld the articles noting that the statutory rule only provided that the quorum could not be less than what it provided, there was no upper limit. The parties had the contractual freedom to ‘contract over’ the mandate.
The ICDR Regulations provide that if the company opting for preferential allotment has been listed for more than twenty-six weeks, then the allotment price “shall not be less than” the higher of the two aforementioned prescribed prices. This is a mandatory rule disallowing any contractual deviation. In Mannalal Khetan v Kedar Nath Khetan, the Supreme Court considered whether the provision of registration of transfer of shares under the erstwhile Companies Act, 1956 were mandatory. The Court answered in affirmative principally on two grounds: firstly, that the provision used negative words (“shall not”), which could only be used in a mandatory enactment; and secondly, that non-adherence to the provision incurred a penalty. Both these conditions are satisfied in relation to Regulation 164(1) of ICDR, as it uses negative language and non-compliance to the same is punishable under the Securities and Exchange Board of India Act, 1992. The SAT presiding officer’s opinion read this mandatory rule as both proscribing contracting out and contracting over, while the judicial member correctly determined that PNBHF’s articles contracted over the rule and were therefore, valid.
Unfortunately, due to a vacancy in the three-member SAT, the matter remained at a standstill. The SEBI initially filed an appeal before the Supreme Court but the investors withdrew their interest and the matter was rendered infructuous. If it had been decided at the highest level, it would have answered an interesting question on the hierarchy of norms in Indian company law. Perhaps in the future, the SAT or the Supreme Court will have an opportunity to effectively rule on the mandatory nature of the Indian company law and permissibility of contractual modification.