Entrenchment provisions occupy a very sensitive position in the corporate governance rules as well as the companies' operations. Generally, entrenchment provisions are special clauses annexed to the charter documents of a company. These can be the memorandum or articles of association. Of course, the basic function of these provisions is to protect certain rights and make it relatively difficult to change or abolish certain rules.
It is in the framework of the Companies Act that these provisions often find use by corporations to safeguard very critical decision-making processes, rights of shareholders, or governance structures. The presence of such provisions may affect the ease or difficulty with which the company can modify its internal rules so as to help ensure stability or guarding the interest of some specific group, be it promoters or founding members.
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Definition of Entrenchment Provision
An entrenchment provision is generally one that makes certain rules in a firm's governing documents impossible or hard to amend. Such provisions are typically intended to act as a safeguard for key features of a firm's organization, governance, or decision-making processes by making changes harder to enact through supermajority requirements. For example, an entrenchment provision would be a provision that requires a supermajority vote just to amend the articles of a corporation. This mechanism helps ensure that some of the fundamental aspects of the company are not altered without broad shareholder consensus.
Key characteristics of an entrenchment clause in AoA:
An entrenchment clause in the AoA of the company is such a provision that makes it challenging to change certain aspects of the company's governance. Specifically, they require a higher threshold than usual for amending certain parts of the AoA. This might include the requirement of a special resolution, a supermajority vote, or the consent of specific groups of shareholders or directors before certain provisions may be altered.
1. Higher Threshold for Amendments:
An entrenchment clause often requires the alteration of particular provisions of the AoA to take place only through a more severe process than that which is normal procedure for the alteration of the AoA. For example, the clause can require special resolution—a vote having to be carried by at least a 75% majority of shareholders—or even be unanimous to have amendments pass certain provisions.
2. Protection for Minority Interests:
They are often utilized to safeguard the rights of specific shareholders, including minority or preferred shareholders, by making it nearly impossible for a majority of shareholders to alter provisions that favor the minority. For instance, the entrenchment clause might safeguard provisions in the articles relating to voting rights, the distribution of dividends, or the election of directors for minority shareholders.
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3. Governance Stability
An entrenchment provision stabilizes the body political and ensures that critical governance provisions, which may include, but are not limited to, director appointment procedures or quorum requirements, can't be altered easily by a short-term shift in the shareholder base or by large controlling parties seeking to alter the firm's direction.
4. Example of Provisions Subject to Entrenchment
Voting rights: provisions granting special voting rights or veto powers to certain classes of shares or shareholders.
Director appointments: Preservation of board of directors structure through requirement of certain approvals from specific shareholders in respect of particular appointments.
Policies regarding dividends: Ensuring the distribution of a specific percentage of profit to certain shareholders or classes of shares.
Corporate actions: Inhibiting certain decisions, such as mergers or takeovers, which may hurt the interests of a particular group of shareholders.
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Legal Framework
Jurisdiction: Entrenchment clauses, depending upon the jurisdiction, are either allowed to be there in private companies or permitted but scrutinized if they are said to be unfairly prejudicial to shareholders and fall foul of mandatory legal provisions. In other words, jurisdictions may not enforce clauses that go against the framework of corporate law or are against public policy.
Incorporation: Entrenchment provisions should be explicitly incorporated in the AoA (or the equivalent governing document of a company) at incorporation or by amendments subsequent to incorporation. A well-drafted entrenchment clause should clearly specify what provisions are protected and how they can be amended or repealed.
Example:
Consider an entrenchment clause that contains a stipulation that only a 90% majority vote shall amend the procedure for electing the board of directors. This makes it significantly more difficult for a majority shareholder, or any number of shareholders, to alter the procedure by which the board is elected, thus protecting stability and minority interests.
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Legal Basis of Entrenchment Provisions in AOA
Provisions to entrench are governed mainly through the company's articles of association under the Companies Act, 2013. The Act provides specific legal frameworks for companies to be implemented and put into practice, therefore ensuring they must abide by the regulatory standards without neglecting protective measures for governance structures.
The following are prominent features in regard to the Companies Act about the issue of entrenchment:
Section 5 of the Companies Act, 2013: This section also allows the company to adopt or modify its articles of association. But anything to be available in the articles can only be changed with the consent of shareholders in the manner prescribed in the act.
Section 14 of the Companies Act, 2013: Section 14 empowers a company to make alterations of its articles of association with special resolution of the company. However, if the company desires an entrenchment provision, articles must be expressed to that effect, and also the mechanism for changing those provisions must be clearly provided.
Section 25 of the Companies Act, 2013: It deals with the alteration of memorandum and articles, which should be done only by following certain judicial procedures. The entrenchment provisions should therefore be in line with these procedures to make sure that the company does not operate in a way deemed illegal.
Model Articles of Association for Companies: In particular circumstances, the Model Articles of the Companies Act allow companies to include entrenchment provisions simply by formally declaring that they are part and parcel of their articles of association. Such provisions will hold that certain clauses cannot be altered except upon stricter special procedures provided.
Benefits of Entrenchment Provisions
Entrenchment provisions can provide some benefits for companies. These include
Protection of Shareholder Interests: To the extent that entrenchment provisions ensure that critical decisions require broad approval, they ensure that minority shareholders do not get outvoted on important matters.
Governance Stability: It helps maintain stability in the company's operations as it protects key governance mechanisms from frequent and capricious changes.
Protecting Promoter Control: It ensures certain decisions are not taken without the promoters' approval, which is quite crucial in close-holding companies.
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Disadvantages of Entrenchment Provisions
While entrenchment provisions can afford some degree of security, there are a couple of disadvantages in the following ways:
Less Flexibility: Entrenchment provisions may make the company unresponsive to changes in the environment in which the business is taking place, especially in major reforms.
Minority Shareholder Disempowerment: Provisions may give unchecked rights to some shareholders as a result of disenfranchising the interests of minority shareholders.
Potential for Abuse: In severely limiting entrenchment provisions, a few may even entrench their control at the cost of shareholder democracy.
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Conclusion
The entrenchment provisions under the Companies Act are powerful tools for safeguarding governance rights, specifically ensuring that a company remains stable in the long term. Although entrenchment provisions are very beneficial in considering the safeguarding of shareholders' interests and control, there is a risk regarding governance flexibility and minority rights. Hence, companies need to be very careful in striking a balance while including these provisions so that they still protect the interests of their shareholders and remain compliant with the requirements under the law.
Entrenchment Provision FAQs
Q1. What is an entrenchment provision under the Companies Act?
An entrenchment provision refers to a clause incorporated in the company's articles of association that makes some provisions difficult or hard to amend or remove.
Q2. Can a company include an entrenchment provision without shareholder approval?
No, no provision can be made entrenching without shareholder approval at the hands of a special resolution.
Q3. What is the impact of entrenchment provisions on company governance?
Provisions can stabilize governance but limit flexibility and democratic decision-making, primarily when changes within the governance structure are in order.
Q4. Are the entrenchment provisions permanent?
No, since entrenchment provisions can be amended or deleted using, but typically only for more complex procedures than ordinary amendments.
Q5. Are entrenchment provisions common in public companies?
Entrenchment provisions will be more regularly seen in privatised firms or closely held corporations where the interests of some shareholders require protection.
