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-Kopal Mital†
Introduction
This paper argues that in interpreting the ‘sufficient cause’ standard in section 58(4), Companies Act 2013, tribunals/courts should assess whether the decision of the company’s board of directors to refuse the registration of shares was in the best interests of the company and its shareholders. It draws out this approach from Synthite Industries Limited v. M/s Plant Lipids (P) Ltd. and Others, a 2018 NCLAT judgement and locates it within section 166 of the 2013 Act. It demonstrates that this judgement provides a better approach to deciding sufficient cause than Mackintosh Burn Ltd v. Sarkar and Choudhary Enterprises Pvt. Ltd. It also highlights the advantages of this approach through the lens of agency costs and market for corporate control.
As opposed to private companies, shares of public companies are freely transferable as per sections 2(71) and 58(2). Freedom to buy and sell shares allows investors to become shareholders in various companies and also enhances liquidity. However, constant entry into and exit out of companies would pose a significant challenge in its management, sharing and, maintaining control. For stability, statutes of various jurisdictions have permitted public companies to place restrictions on free transferability of shares. In India, imposition of restrictions is allowed under proviso to section 58(2). Call option, right of first refusal or offer, are a few of the common contractual restrictions which can be found even in a public company’s Articles of Association (‘AoA’). Refusal to register transferred shares under section 58(4) can also be seen as a restriction on the free transferability of shares of public companies as on such refusal,[1] the sale of shares will not be complete.
Sufficient Cause: A Proposal to Move from Mackintosh to Synthite
Sufficient cause in section 58(4) is an example of a standard. Standards provide discretion to the deciding authority to examine actions ex post. Compared to rules, which disallow specific actions ex ante, standards are broader. Therefore, standards demand a more engaged assessment from the courts/tribunals. The decisions rendered over a period of time act as guides to the future adjudicating authorities and result in a clearer standard being set.[2]
Drawing on this, the next part examines the manner in which the ‘sufficient’ cause standard was dealt with by the courts under the 1956 Companies Act. With this brief look into the history of the section, it analyses courts approache to cases that have arisen under the 2013 Act.
Companies Act, 1956
The antecedent to section 58(4) is section 111A(2) in Companies Act, 1956. In deciding sufficient cause under the 1956 Act, courts seemed to be split. A few tribunals/courts held that ‘sufficient cause’ was limited to violation of law as provided under section 111A(3).[3] Others seemed to reason that ‘sufficient cause’ went beyond contravention of law.[4] Therefore, there was no clear position on the scope of sufficient cause under the 1956 Act. It is important to note that the phrasing of ‘sufficient cause’ remained the same under the 2013 Act as well.
After the enactment of the 2013 Act, Mackintosh Burn Ltd v. Sarkar and Choudhary Enterprises Pvt. Ltd. (‘Mackintosh’) was one of the first cases in which the scope of ‘sufficient cause’ under section 58(4) was decided. This decision seemed to provide clarity to an extent.
Mackintosh Burn Ltd v. Sarkar and Choudhary Enterprises Pvt. Ltd
Sarkar Enterprises sought to register the 100 shares they had purchased. This was refused by Mackintosh Limited. It reasoned that the respondent company, Sarkar Enterprises, was controlled by its competitor, hence, such a transfer would be detrimental. The Calcutta Company Law Board held that only illegality or inadmissibility under law qualified as ‘sufficient cause’ under section 58(4). The Supreme Court (‘SC’) found this reasoning restrictive and held that ‘sufficient cause’ encompassed more than just contravention of law. It explained that ‘sufficient cause’ would be a mixed question of law and fact which would vary depending on the case facts. In the context of Mackintosh, SC concluded that there was a conflict of interest and this qualified as ‘sufficient cause’ for refusing registration of shares. Presumably, SC found it to be a conflict of interest because the companies were competitors. It briefly indicated that the mala fide actions of Sarkar Enterprises should have been considered. In this way, the SC widened the scope of this standard. However, the decision provides no direction about the parameters to be used when adjudging sufficient cause. This creates unpredictability and uncertainty. In this regard, Synthite Industries Limited v. M/s Plant Lipids (P) Ltd. and Others (‘Synthite’), an NCLAT judgement is more informative.
The strength of the NCLAT decision lies in its recognition that both the landmark judgements of Bajaj Auto Ltd. v. Company Law Board (‘Bajaj’)and Bajaj Auto Limited v. N.K. Firodia (‘Firodia’). Bajaj and Firodia arose in the context of the 1956 Act and Synthite would have to be decided as per the 2013 Act. The Tribunal in Synthite neither ignored the decision in Mackintosh nor it allowed the Bajaj and Firodia principles to overshadow the 2013 Act. Instead, it incorporated the principles within the framework of the 2013 Act by using it as a guide to determine sufficient cause under section 58(4).
The next section looks into the Synthite decision in detail.
Synthite Industries Limited v. M/s Plant Lipids (P) Ltd. and Others
Similar to Mackintosh, Plant Lipids, the company buying the shares was a competitor of Synthite Industries. This was one of the main reasons given by Synthite for refusing registration of shares. It further alleged that Plant Lipids was acting in a mala fide manner and its aim was to acquire shares to gain control and create hindrances in the management of Synthite. Strictly following Mackintosh, the Tribunal could have stopped its analysis here. However, the Tribunal in looking into the sufficiency of the cause examined whether the power of refusal conferred by the AoA on the Board of Directors was exercised in a bona fide manner. The decision of the Tribunal to embark on this inquiry was influenced by Bajaj. The SC in Bajaj held that the decision of the company’s directors to refuse registration of shares must be informed by the interest of the company and its shareholders. A closer look into Bajaj reveals that it draws on Firodia. In Firodia, the SC held that in refusing to register shares, directors must perform their fiduciary duty and the decision must be in the best interests of the company and its shareholders. It further held that in determining whether directors acted in good faith, tribunals/courts could look into whether the decision was based on sound principles and devoid of ‘oblique motives.’
Being informed by these principles, to satisfy itself of the sufficiency of the cause, the Tribunal in Synthite, looked into whether the decision of the directors was in the interest of the company and its shareholders. To this extent, it independently assessed whether the apprehensions of the directors about hostile takeover were real or not. For this, it examined the manner and circumstances in which Plant Lipids had decided to buy the shares of Synthite Industries. The Tribunal found that Managing Director of Plant Lipids through a resolution decided to buy 15,000 shares in Synthite through either on or off market purchases. While the dispute in the present petition was about refusal to register the purchase of 25 shares, the resolutions demonstrated the clear intent of the Managing Director of Plant Lipids to ultimately buy many more shares. These resolutions were key and it led to the Tribunal recognizing the intent of hostile takeover thereby making Synthite’s apprehension a reasonable one. It held that the decision to refuse registration of shares was to protect the company and shareholders because Plant Lipids was indeed acting in bad faith. This was further supported by the fact that the decision to buy these shares was taken when Synthite was in the process of converting itself from a public to a private limited company. The timing of the investment was seen as a tactic employed by the management of Plant Lipids to create obstacles in the conversion process. It was trying to hinder Synthite’s management by attempting to introduce outsiders by buying these shares. After undertaking this independent analysis, the Tribunal held that decision to refuse the registration of transfer was neither arbitrary nor lacking in bona fides. In ‘deferring to the Board’s wisdom’ to refuse the registration of the transferred shares, the Tribunal concluded that the standard of sufficient cause had been met by the directors as they had acted in the interest of the company and its shareholders. The Tribunal seemed to indicate that the directors had performed their fiduciary duty.
This approach of linking the directors’ fiduciary duties to act in the interest of the company and shareholders with determination of sufficient cause for refusal now finds stronger support in the Companies Act, 2013 which has now codified directors’ duties. Particularly, section 166(2) obligates the directors to act in a bona fide manner and advance the company’s and shareholders’ best interest. Therefore, what emerges is that in assessing sufficient cause under section 58(4) adjudicating authorities should look at whether directors are fulfilling their duty under section 166(2). This would require the authorities to look into whether the decision to refuse registration of transferred shares was taken with a view to advance the interests of the company and its shareholders.
It is interesting to note that if the Synthite reasoning is applied to Mackintosh now, perhaps, the end result would not change. This is because in refusing to register the shares, the Mackintosh Burns Limited. was acting to protect the company and shareholders. However, Synthite is a better decision because it develops thorough reasoning and parameters on which sufficient cause can be adjudged. This would provide guidance to future decision-makers and as mentioned above, would help set a clearer standard bringing predictability and clarity.
Advantages
The proposed approach has clear advantages, particularly, when viewed from the lens of market for corporate control and agency costs.
Market for Corporate Control
Adjudging ‘sufficient cause’ on the touchstone of company and shareholder interest creates an effect similar to that of market for corporate control. Free transferability of shares enables an interested challenger to buy shares from disaggregated current shareholders who wish to exit the company due to its poor performance.[5]With enough shares the challenger would be able to gain sufficient control and displace the incumbents. The possibility of such takeovers keeps incumbent managers on their toes. In this manner, the market for corporate control ensures efficiency. However, using its power to refuse registration of transferred shares, the incumbent can prevent the challenger from gaining any control. This could possibly hinder the natural operation of the market for corporate control. It is here that the role of the tribunal in deciding ‘sufficient cause’ under section 58(4) becomes crucial. Following the proposed approach, the directors of the company will have to provide reasons for refusing to register the transferred shares. The fact that directors have to provide reasons for their actions automatically institutes a transparency and accountability mechanism. Further, these reasons will be adjudged on the grounds of whether the move was in the favour of the company and its shareholder. If the directors are actually working in the best interest of the company and shareholders, the standard is wide enough to accommodate legitimate concerns of hostile takeovers like in Synthite. It is also detailed enough for the tribunal to uncover situations where directors were trying to prevent registration of shares to further their own self-interest, like in Firodia.[6] Therefore, incumbents will not be able to use their power to refuse as a shield to disallow any and all transfer of shares and change of control. In this way, like the market for corporate control, the tribunal will also ensure efficiency.
Reduction of Agency Costs
This approach would empower tribunal/courts to minimize agency costs which arises due to uncertainty in the mind of shareholders (principals) as to whether the board (agents) is working in their favour or not.[7] In deciding on ‘sufficient cause’ they would see whether the board (agents) is performing its duty under section 166 by acting in the interest of the shareholders (principals). As seen above in Synthite, the Tribunal undertook an enquiry into both the circumstances in which the registration was refused as well as the resolution which contained the reasons given by the Board for such refusal. In Mackintosh, while there was no resolution passed by the Board, in defending itself before the Tribunal, they had to provide their reasons. In bringing these reasons to the forefront, it would also allow shareholders a glimpse into the manner in which the boards are functioning. It would provide further information since the courts/tribunals would assess whether the decision was in the best interest of the company and the shareholders. Therefore, even if clear resolutions are not passed, when parties approach the tribunal/courts, they will have to provide reasons. Thus, the information asymmetry that generally exists between the board and the shareholders in terms of whether favourable action is being taken will be reduced.
Conclusion
This paper highlights that while the standard in the 2013 Act and 1956 Act is the same, there is a change in the manner in which the sufficient cause has come to be interpreted under the 2013 Act. Through an analysis of the cases that have arisen under the 2013 Act, it shows that courts/tribunals should employ the reasoning of NCLAT in Synthite when deciding ‘sufficient cause’ under section 58(4). This approach finds support in the Companies Act, 2013 which has crystallised the duties of directors and its obligations to act in the favour of the company and its shareholders under section 166(2). The paper also highlights the advantages this approach has in terms of the functioning of the market for corporate control and reduction of agency costs. It is hoped that the courts build on this reasoning to ensure that the decisions about registration of shares is in the best interest of all the stakeholders (like the company and its shareholders) and not just those having the day-to-day control of the company.
†Kopal Mital is a IV year student at NLSIU, Bangalore.
[1] Mackintosh Burn Ltd v. Sarkar and Choudhary Enterprises Pvt. Ltd. (2018) 5 SCC 575 [13]. [2] Reiner Kraakman and others, The Anatomy of Corporate Law (3rd edn, OUP 2017) 37-38 <https://books.google.co.in/books/about/The_Anatomy_of_Corporate_Law_A_Comparati.html?id=-1VnWGrgID0C&redir_esc=y> accessed 12 January 2022. [3] Estate Investment v. Sitlap Chemicals Ltd 1998 SCC OnLine CLB 28 [17]; Azzilfi Finlease and Investments Pvt. Ltd. v. Ambalal Sarabhai Enterprises Ltd [11]. [4] Karamsad Investments Ltd. v. Nile Ltd. 2001 SCC OnLine AP 1199 [58-59]; E-first Technologies Pvt. Ltd. v. Hiperworld Cybertech Ltd. 2004 SCC OnLine CLB 46 [11-12]. [5] Kraakman (n 2), 34. [6] In this case, Bajaj Auto refused to register the transfer of 3646 shares bought by the Respondents. One among them was N.K. Firodia. It was found the decision to refuse registration of shares was motivated by the intent to ensure that the ‘hegemony’ of the Bajaj group continue. It was found that the Directors had not acted in the interest of the company or the shareholders. Rather, they had acted to ensure that Firodia be removed from management control altogether. [7] Kraakman (n 2).