Right of First Refusal Is Not a Restriction on Free Transferability Under Section 111A

Introduction

1. The concept of free transferability of shares in a public company under section 111A of the Companies Act, 1956 is perhaps the most significant unresolved controversy in contemporary Indian corporate law. Time and again the issue has arisen whether the right of first refusal (pre-emptive rights) in the shareholders’ agreement and joint venture agreement constitute restriction on the free transferability of shares. Right of first refusal is a commonly used device in the corporate world. Under the right of first refusal, a second party planning to exit the company, is obliged to give the first party ( promoter) an opportunity to buy the shares before the shares can be sold to a third party which is an outside party. This is basically to prevent an easy entry of third party into the company by purchasing shares from the party who wish to exit the company. Many corporates, unlisted as well as some listed ones, have such agreements with large shareholders.

Right of first refusal whether violate section 111A

2. In the recent judgment by a Division Bench of the Bombay High Court in the case of Messer Holdings Ltd. v. Shyam Madanmohan Ruia decided on 1st September, 2010 and reported in [2010] 98 CLA 325 has ruled that restriction on transfer of share with the “right of first refusal’ (pre-emtive) clause in the agreement does not violate the provisions of section 111A. In paragraph 55, Khanwilkar, J, held as follows:

‘[T]he expression “freely transferable” in section 111A does not mean that the shareholder cannot enter into consensual arrangement/agreement with the third party (proposed transferee) in relation to his specific shares. If the company wants to even prohibit that right of the shareholders, may have to provide for an express condition in the articles of association or in the Act and Rules, as the case may be, in that behalf. The legal provision as obtained in the form of section 111A of the Companies Act does not expressly restrict or take away the right of shareholders to enter into consensual arrangement/agreement in respect of shares held by him.

This is a reversal of an earlier judgment of the Single Judge in the case of Western Maharashtra Development Corporation v. Bajaj Auto Ltd. [2010] CLA 131(Bom.) decided on 15th February, 2010 which held that section 111A mandates that there can be no restriction whatsoever on the transferability of shares in a public company. Consequently, an agreement granting a right of pre-emption in respect of such shares has been held patently illegal. Justice D Y Chandrachud in the said case held as follows:

‘The principle of free transferability must be given a broad dimension in order to fulfil the object of the law. Imposing restrictions on the principle of free transferability, is a legislative function, simply because the postulate of free transferability was enunciated as a matter of legislative policy when Parliament introduced section 111A. That is a binding precept which governs the discourse on transferability of shares. The word “transferable” is of the widest possible import and Parliament by using the expression “freely transferable”, has reinforced the legislative intent of allowing transfers of shares of public companies in a free and efficient domain. The effect of a clause of pre-emption is to impose a restriction on the free transferability of the shares by subjecting the norms of transferability laid down in section 111A to a pre-emptive right created by the agreement between the parties. This is impermissible.’

This judgment in the case of Western Maharashtra (supra) had infact put Corporate India in a fix, with many companies facing the prospect of having to rework their share agreements with external investors. However, the recent ruling of Messer Holdings Ltd. (supra) has come as a big relief for both companies and private equity funds which invest in these firms. The judgment also goes on to suggest that it is not mandatory for the company to be a party to such an agreement relating to share transfer restrictions and it is not necessary to incorporate share transfer restrictions in the articles of association of the company.

Section 111A does not apply to a private company

3. Restriction of transferability of shares in a private company has to be contrasted with cases involving public companies where the law provides for free transferability. Free transferability of shares is the norm in the case of shares in a public company. As far as private companies are concerned, the articles of association restrict shareholders’ rights to transfer the shares and prohibit invitation to the public to subscribe to shares or debentures of the company. In the case of V B Rangaraj v. V B Gopalakrishnan [1991] 6 CLA 211 the Supreme Court has pointed out that the transfer of shares in the case of private company is regulated by the company’s articles of association and that any restriction which is not specified in the articles is not binding either on the company or on the shareholders. As regards public company in the case of Pushpa Katoch v. Manu Maharani Hotels Ltd.

[2005] 69 CLA 151 (Del.) it was ruled that even if right of first refusal has been incorporated in the articles of association, a shareholder cannot be restricted from transferring the shares since section 111A which applies to public companies provides for free transferability of shares.

Concept of free transferability as held in Messers Holdings Ltd. case

4. The question before Messer Holdings Ltd. (supra) was whether pre-emptive right can be said to be violative of free transferability of shares provided by section 111A. In this context reference may be made to the provisions of sub-section (2) of section 111A which opens with the expression “subject to the provisions of this section, the shares or debentures and any interest therein of a company shall be freely transferable”. In other words, it is a provision restating that the shares or debentures and any interest therein of a company shall be freely transferable subject, however, to the stipulation provided in the other part of section 111A. The proviso to sub-section (2) reinforces the position that section 111A is to regulate the powers of the Board of directors of the company regarding transfer of shares or debentures and any interest therein of a company. The Board of directors cannot refuse to register transfer of shares unless there is sufficient cause to do so.

4.1 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.

The fact that shares of public company can be subscribed and there is no prohibition for invitation to the public to subscribe to shares, unlike in the case of private company, does not whittle down the right of the shareholder of a public company to arrive at consensual agreement which is otherwise in conformity with the extant regulations and the governing laws.

Conclusion

5. While the recent judgment of Messers Holdings (supra) offers strategic investors the much-needed reprieve, legal experts believe that some corporates are likely to knock on the doors of the Supreme Court looking for clarity since it has great impact on various joint venture agreement across corporate India. Some experts feel that share transfer restriction has to be there in every agreement. The debate on enforceability of terms of shareholder agreements governing public limited companies is definitely not over yet.