Entrenchment clause – Question mark on Validity!
Vijay Kumar (Lawyer, Madras High Court)
The Companies Act, 2013 has introduced “entrenchment” in Articles of Association. What is “Entrenchment”? As per the Oxford Dictionary “Entrenchment” means “to apply additional legal safeguards”. In legal sense it means addition of provision which makes certain amendments either more difficult or cumbersome by way of procedure or checks and safeguards. Section 5(3) of the Companies Act, 2013 for entrenchment. For ease of reference the said Section is reproduced below:
“ The articles may contain provisions for entrenchment to the effect that specified provisions of the articles may be altered only if conditions or procedures as that are more restrictive than those applicable in the case of a special resolution are met or complied with.”
Articles of Association of the Company is a business document that provides for regulations to manage the affairs of the Company. It is an agreement between the shareholders and between the Company and the shareholders. It is a public document and shareholders are presumed to have constructive notice of the regulations of the Articles of Association of the Company.
Whether the Companies Act, 1956 provided for entrenchment clause or is it an introduction made in the Companies Act, 2013? Though there was nothing specific as “entrenchment” Clause in Companies Act, 1956, the Old Act did recognise the concept of additional legal safeguards and checks and controls through judicial decisions. The Supreme Court in V.B. Rangaraj vs V.B Gopalakrishnan [1] laid down the law that private agreement between shareholders would not bind the Company unless the Articles of Association of the Company provides for such restrictions. The New Act refers to “Amendment of specified clauses of Articles of Association” as the entrenchment Clause. In effect it means that Articles of Association is a constitution document of the Company and any amendment to the specified Clauses Articles of Association may require additional conditions to be fulfilled which clauses are referred to as Entrenchment Clauses. Amendment of specified clauses also would include addition of new clauses in the Articles.
The New Act does not define entrenchment nor provides an explanation for identifying entrenchment Clause. As stated supra, entrenchment has been provided only with reference to amendment to Articles of Association. The entrenchment clause when introduced by an existing private Company, the same needs to be approved by all shareholders and in case of public limited Company the same needs to be approved by Special resolution. The reason for variance in manner of voting in Private and Public Company limited by shares for introduction of entrenchment Clause is not reasoned. In fact there needs to be special procedure even to introduce such entrenchment Clause in Public Company as Promoters may overpower the minority shareholders and bring in these restrictions much against the wish of minority.
Eg: Unless the Agarwal family which holds not less than 10% of paid up capital of the Company (Listed) votes in favour of amendment of Articles of Association, there cannot be any amendment of Articles. This Clause is unreasonable in case of public listed Company
The Entrenchment Clause, however, needs to be in accordance with the Memorandum of Association of the Company and the Companies Act, 2013. Any entrenchment Clause which is against the provision of Companies Act, 2013 or Memorandum of Association is void and unenforceable. The additional safeguard provided by the Entrenchment Clause will raise number of legal issues about their validity. Whether the validity of Entrenchment Clause can be tested on the grounds of reasonableness is a moot question. For example-
- Whether any Clause in the Articles of Association which grants special rights in terms of voting or veto power to a minority group against the wisdom of majority of shareholders is valid or is such clause against the very basis of corporate democracy of one share one vote and that all shares rank pari passu?
- Can a public listed Company by virtue of entrenchment Clause grant special privilege to its Promoters in terms of voting powers on Amendment to Articles of Association?
Entrenchment Clause as defined supra requires registration with Registrar of Companies. Any clause in Articles which grants veto right to Banks or Venture Capital Investor on issues/proposal of Company like raising of capital, sale of undertaking of the Company etc. are not entrenchment Clauses and are mere clauses regulating the business decision making of the Company.
Finally, the term ‘Entrenchment’ and the procedure associated with it is an introduction in the New Act. However the concept of additional safeguards or additional compliance for bringing about amendment to Articles which is constitutional document of Company has always been recognised. It is shareholders document and shareholders are free to agree upon its terms.