by Sandhya Sridhar
The Bombay High Court in Balaji Auto Ltd. v. Western Maharashtra Development Corporation Ltd. has clarified legislative intent of Section 111A of the Companies Act, 1956 (hereinafter “the Act”) and Section 22A of the Securities (Contract) Regulation Act, 1956 (hereinafter “SCRA”) with regard to the enforceability of the pre-emption clause granting the right of first refusal in a shareholders’ agreement that it does not constitute a restriction on the concept of “free transferability” of shares.The Court recognised that the shares of the company are movable property and identified this with regard to the right of exercise of proprietary rights including the right of alienation of the shares and the right to enter into consensual agreement that would impose fetters on their ability to alienate. Recognising such arrangements as commonplace in agreements involving joint ventures, private equity, venture capital and other investment transaction specifying rights, duties, powers of shareholders enforceable qua shareholders above and beyond the memorandum and the articles of the company with regard to holding and disposal of investments, the Court overruled the Division Bench’s ruling that such agreements imposing fetters on the transferability of shares and therefore “patently illegal” as against the key provisions of Act and the governing regulations.
The Court expressly relying on the case of Messer Holdings v. Shyam Madanmohan Ruia and whilst reaffirming the current position of law as under Section 58 of the Companies Act, 2013 which takes note of such conditionality that the securities or other interests of any member in a public company shall be freely transferable provided that any contract or arrangement between persons in respect of transfer of securities is to be enforceable as a contract, the Court distinguished the enforceability of transfer restrictions in two respects, firstly, as against the Indian law, viz, the Act and the SCRA and secondly, as against the shareholders enforceable inter se. The Court’s rationale followed the proposition in Messer Holdings that opined that the shareholder has the freedom to transfer his shares on the terms defined by him, such as the right to first refusal, in consonance with other regulations including repurchasing the shares at the prevailing market price when such offer is made.
Primarily clarifying the legislative intent as to the concept of free transferability of shares as under Section 111A of the Act, the Court affirmed that Section 111A has no bearing on or that it does not restrict, affect or take away a shareholders’ right to enter into covenants to deal with their shares by the way of sale, pledge or pre-emption. On plain reading of the Section, it is to ensure that the Board of Directors of a public company cannot refuse transfer of shares without attributing sufficient cause except under the circumstances specified in the proviso. Further, in line with the above interpretation, the Court clarified that Section 22A of the SCRA which similarly stipulated free transferability of listed securities, registration of such transfers and circumstances where the Board may refuse restrictions, such arrangements for sale, pledge, pre-emption or otherwise consensually entered into by the shareholders either at present or at a future date does not impinge or violate the concept contemplated under Section 22A. The main intent of enacting this proviso is to particularly reduce the undue burden on the small investors as against the abuse of discretionary powers of the Board to refuse registration of transfer of shares.
This reasoning of the Court with regard to the case clarified and summed up the following:
- The Protocol Agreement is a consensual arrangement entered into by the parties to this dispute wherein Clause 7 granted the right of first refusal to the Appellant to purchase the shareholding of the Respondent; the same is not affected by Section 111A of the Act or its predecessor viz., Section 22A of the SCRA. Also merely because the Protocol Agreement was incorporated in the Articles of Association of the company does not mean it is invalid.
- This Appeal overrules the ruling of the Division Bench and upholds the validity of Clause 7 as enforceable as against the consenting shareholders to sell its shares at the price agreed upon without impinging upon the law. Additionally, the joint reference on the appointment of a Sole Arbitrator for the assignment to determine the value of shares is good in law and was enforceable as against the Appellant and the Respondent since it did not affect the rights and liabilities of the other members of the company.
After accepting the vast interpretation of the key provisions of law hereinabove on the issue of transferability of shares, the judgment envisages the lawfulness of the arrangement Clause 7 seeks to build, in tandem with the point on lawful notice specifying the offer to sell such shares at the rate specified; the right to re-negotiate the purchase price if it is too high or unacceptable; the right to freely sell shares to any other person if the other party fails to accept the proposal. This is in light of the fact that the Appellant holds 24% of the shareholding, the Respondent, 27% and the public, the balance 49% in MSL. The Court viewed the right of first refusal as an obligation upon the selling shareholder not to sell its shares to a third party without offering his shares to other existing shareholders. Hence, in a contractual setting, it is to be seen as a contingent option granted to the existing shareholders to purchase the shares if the holder elects to sell it.
The judgment therefore has the following outcomes with regard to the issue on free transferability:
- A shareholders agreement containing a pre-emptive clause, whether incorporated in the Articles of the company or not, is not in violation of the provisions of the Companies Act or the SCRA leading to a more clarified position on the legislative intent behind the enactment of Section 111A of the 1956 Act and Section 22A of the SCRA with regard to the interpretation of free transferability of shares. Hence, it is now clear that the law does not intend to circumscribe the right of a shareholder to create contractual restrictions but only intends to reduce the instances where the Board can abuse its discretion to refuse registration of shares. This intends to remove the infirmity set by the Division Bench’s ruling that created far-reaching consequence on banks, financial institutions, regulators and stock exchanges. Hence it is declared that free transferability is no bar to the validity of contractual arrangements in tandem of the current applicable law viz., Section 44 and Section 58 of the Companies Act, 2013 with regard to contractual enforcement.
- There is now more clarity on the matter with regard to the position on the execution of agreements involving exit options towards negotiating to protect commercial interests in arrangements involving Private Equity/ Strategic Partnerships to negotiate right of first refusal or tag/drag along rights with the Promoters may be done so without imposing any fetters on the owner of such shares.
- The situation with regard to private companies has been more explicit in terms of Section 3(1) (iii) of the 1956 Act that requires a private company to stipulate restrictions on the transfer of shares in its articles of association and Section 9 of the Act makes void those provisions of the Charter documents or any agreements of the company which are contrary to the provisions of the Act. Therefore, private companies, by definition are required to incorporate restrictions on transferability in their articles of association. Section 58(1) of the Companies Act, 2013 presupposes the procedure for such registration of or refusal to register thereof in pursuance of the company’s powers prescribed in the Articles.
- More widely, the outcome of the judgment can be accessed towards a more healthy growth of the capital markets through the conditions that are progressive to the free marketability of shares in its true essence.
In conclusion, this judgment has clarified the muddied concept of enforceability of share transfer restriction in a specific and affirmative manner, thus reducing the hurdles on executing and enforcing private covenants between shareholders’ dictating the terms where under the parties may dispose off their investments protecting their commercial interests in the company as long as such terms are in consonance with the Companies Act, the Articles of the company and other regulatory provisions.
Sandhya is a fifth year student at HNLU