Context
A fundamental trait that distinguishes a private company from a public company is the concept of ‘transferability of shares,’ such that while the former may restrict transferability of shares, the shares of the latter, are generally considered to be ‘freely transferable’.
However, incoming investors often prefer placing restrictions on transferability of shares, on either the promoters or other shareholder groups, by way of additional clauses in the shareholders’ agreement, or any other consensual arrangements that they may enter into. These clauses allow incoming investors to protect their own interests, primarily by allowing them to ensure they do not get diluted and limit unknown third-party shareholders from being involved in the company. Common contractual provisions imposing restrictions/ conditions on share transferability are in the form of lock-in, prior consent for transfer, right of first refusal/right of first offer, drag-along rights, tag-along rights, restrictions on inter-se transfer to affiliates, put/ call options (which are typically triggered upon occurrence of EOD events), etc.
This blog focuses on contractual clauses that restrict transferability of shares and their legality and enforceability in India.
Legal Architecture
The concept of ‘free transferability’ of shares in a public company was codified in Section 111A(2) of the erstwhile Companies Act, 1956 (“CA 1956”), which stated that, “Subject to the provisions of this section, the shares or debentures and any interest therein of a company shall be freely transferable.”
The 57th Report of the Parliamentary Standing Committee on the Companies Bill, 2011 sought to “codify the pronouncements made by various Courts holding that contracts relating to transferability of shares of a company entered into by one or more shareholders of a company (which may include promoter or promoter group as a shareholder) shall be enforceable under law.” Section 58(2) of the Companies Act 2013 (“CA 2013”) now reads as under:
“Section 58 – Refusal of registration and appeal against refusal
(2) Without prejudice to sub-section (1), the securities or other interest of any member in a public company shall be freely transferable:
Provided that any contract or arrangement between two or more persons in respect of transfer of securities shall be enforceable as a contract.”
However, the proviso to Section 58(2) is very badly/ unclearly worded and fails to clarify that any contractual rights/ restrictions in respect of share transferability are legally valid. A simpler and better worded proviso would have once and for all put this issue to rest.
The Securities and Exchange Board of India (“SEBI”) has also issued a notification dated October 3, 2013 (“SEBI Notification”), prohibiting any person from entering into any contract with respect to sale or purchase of securities except “… contracts for pre-emption including right of first refusal, or tag-along rights or drag-along rights contained in shareholders agreements or articles of association of companies or other body corporate;”
Jurisprudence
In Western Maharashtra Development Corporation Limited v. Bajaj Auto Limited[1] (“Bajaj Auto Single Judge Decision”),the arbitral award was set aside on the ground that Clause 7 of the Protocol Agreement, which created a right of pre-emption on the shares of a public company was violative of Section 111A of CA 1956. The Single Judge held the award to be patently illegal and contrary to the provisions of law on the following grounds:
- Section 111A of CA 1956 states that the shares of a public company shall be freely transferable, and any restriction on transfer is patently illegal.
- The use of the words ‘freely transferable’ reinforce the legislative intent that the transfer of shares in a public company are free from restrictions.
In Messer Holdings Ltd. v. Shyam Madanmohan Ruia and Ors.[2] (“Messer Holding Decision”), the Share Purchase Agreement contained a ‘right of first refusal’ clause in favour of the Ruias. The question before the Bombay High Court was whether the said clause was illegal and void. While overruling the Bajaj Auto Single Judge Decision and holding the ‘right of first refusal’ clause as valid and enforceable, the Division Bench held that:
“In other words, the setting in which Section 111A is placed in part IV of the Act under leading ‘transfer of shares and debentures’, it is not a provision to curtail the rights of the shareholders to enter into consensual arrangement with the purchaser of their specific shares.
…
The concept of free transferability of shares of a public company is not affected in any manner if the shareholder expresses his willingness to sell the shares held by him to another party with right of first purchase (pre-emption) at the prevailing market price at the relevant time. So long as the member agrees to pay such prevailing market price and abides by other stipulations in the Act, Rules and Articles of Association, there can be no violation. For the sake of free transferability, both the seller and purchaser must agree to the terms of sale. Freedom to purchase cannot mean obligation on the shareholder to sell his shares. The shareholder has freedom to transfer his shares on terms defined by him, such as right of first refusal, provided the terms are consistent with other regulations, including to repurchase the shares at the prevailing market price when such offer is made.” (emphasis supplied)
In Bajaj Auto Limited v. Western Maharashtra Development Corporation Limited[3] (“Bajaj Auto Division Bench Decision”), an appeal was filed against the Bajaj Auto Single Judge Decision. The question once again before the Bombay High Court was whether Clause 7 of the Protocol Agreement, which provided for a right of first refusal to other shareholders impinged upon the free transferability of shares of a public company. While holding in the negative, the Division Bench held that:
- the idea of ‘free transferability’ means that a shareholder has the freedom to transfer his shares in a manner he prefers, so long as it is consistent with the legal framework. Solely because shares of a public company can be subscribed to by the public, does not whittle down the right of a shareholder to enter into an arrangement with a third party, whether for sale, pledge or pre-emption, so long as it is in conformity with the governing law.
- upon reading Section 58 of CA 2013 and the SEBI Notification, they were of the view that Section 58 merely clarifies and codifies the legal position vis-à-vis pre-emption agreements, and what was implicit under Section 111A of CA 1956 is now made explicit in Section 58 of CA 2013.
A similar question arose for discussion before the National Company Law Tribunal (“NCLT”) at Mumbai in Riverdale Infrastructures Private Limited v. Kirloskar Ebara Pumps Limited[4] (“Riverdale Decision”), where the clause in dispute in a Joint Venture Agreement required a party willing to sell, assign, transfer or dispose its shares to seek prior written consent of the other party, and also provided the right of first refusal to the other party. The Bench held that, “while the principle in general is that the shares of a public company are freely transferable, there is nothing in law that stops two or more shareholders from entering into a covenant containing clauses for pre-emption, such as right of first refusal embodied in clause 11.02 of the JVA under consideration in the present Appeal. While this has been recognised through judicial pronouncements under the earlier Companies Act, 1956, the same has now been embodied in the proviso to section 58(2) of the Act.”
Where do we stand now?
A bare reading of the provisions and the jurisprudence stated above lead to two major inferences: first, within the provisions of CA 2013, there is no explicit prohibition, however, given the unclear wording of the proviso to Section 58(2), there is arguably no explicit affirmation on the enforceability of restrictions on transfer of shares and hence it was left upon the Courts to decide the validity; and second, judicial pronouncements have now made it fairly clear that these rights that form a part of a contractual agreement between two parties, whether between majority / minority shareholders and/ or investors, are within the mandate of CA 2013.
However, we believe that Section 58(2) requires to be amended in the next round of amendments to the CA 2013, to ensure that contractual arrangements relating to share transferability, including rights/ restrictions of any nature relating to share transferability, are explicitly codified and recognized as a sub-section within Section 58, rather than a proviso to Section 58(2). This will solve two major problems, namely:
- The judicial pronouncements in the Messer Holding Decision and the Bajaj Auto Division Bench Decision were appealed before the Supreme Court of India and were dismissed without a reasoned order and the Riverdale Decision of the Bombay High Court and NCLT, respectively, is pending before the National Company Law Appellate Tribunal (“NCLAT”). However, as High Courts do not have the benefit of a reasoned Supreme Court order, there is always the possibility of one or more HCs taking a different view, and until set aside by the Supreme Court in an appeal, this will result in conflicting jurisprudence and muddy waters.
- Restrictions/ rights relating to share transferability by way of contractual agreements, as stated above, are recognized in major common law jurisdictions, and are an important consideration for investors investing in India. An explicit mention, to clarify any ambiguity, in CA 2013 will further bolster confidence, and perhaps help avoid apprehensions of litigation, going ahead.
In light of the above, it is our view that a new sub-section in the form of Section 58(2A) be introduced, instead of the proviso to Section 58(2), that is also in line with the SEBI Notification, and may read as follows :
“(2A) any contract or arrangement for restrictions or rights in respect of transfer of securities, inter alia, the right of first refusal/offer, lock-in period, tag-along or drag along rights between two or more persons shall be enforceable as a contract.”
[1] 2010 SCC OnLine Bom 229
[2] 2010 SCC OnLine Bom 2267
[3] 2015 SCC OnLine Bom 2111
[4] Company Appeal No.221/58(4)/MB/2017
