Right Of First Refusal: A Contractual Restriction On Transfer Of Shares


Among various provisions of incorporating documents such as shareholder™s agreement in a corporation, an item will often appear labeled ROFR / Right of First Refusal. ROFR is a contractual right that obliges the selling shareholder not to sell its shares in the company to a third party without offering his shares to another party (usually the other exisiting shareholders). If the existing shareholder(s) does not accept the offer, the selling shareholder is free to sell his stake to a third party, provided the sale is not on more favourable terms than those offered to the existing shareholders. Meaning thereby, the ROFR requires the owner of a property to offer the same to the right holder, on the same terms as those offered by the third party, before the owner can sell the property to that third party. By adopting this provision, the shareholders of the corporation promise that they only will sell their shares after negotiating a price with a third party and offering the shares at that price to their fellow shareholders.

Generally, an investor per se is not interested in investing in ˜cash cows™. Rather, he would prefer an opportunity, which allows him access to an exit window in an approximate period of 3-5 years with a simultaneous increase in returns. To put it succinctly, the contemporary investors prefer a six (as in cricket). Undoubtedly, prudent investors intend for aggressive returns, meaning thereby, they would prefer swinging for the boundaries even at the stake of being out in the process, as opposed to the traditional approach of getting singles. In otherwise, they would prefer to have someone participate in a power packed Twenty20 version of cricket as against the traditional Test Cricket or even the, not so popular, One Day Cricket. The Rights, as enumerated hereunder, it may be noted, are usually there to ensure that, if the boundary has been scored, they can take advantage of the same.

Right of First Refusal in a shareholder™s agreement provides the grantee with a contingent option to purchase an asset if the grantor elects to sell the shares[2]. Before taking into account the legal position with regard to the aforesaid issue, it would be worthwhile to have a brief insight into some of the focal concepts pertaining to the provisions incorporated in agreements such as ˜Joint Venture Agreements™ or ˜Shareholders Agreement™.

These agreements signed amongst the shareholders may include some provisions, which broadly include the following out of which:

(i)             The Right of first refusal;

(ii)           Drag-Along Right; and

(iii)          Tag-Along Right.

And here will annotate Right of first refusal (ROFR), typically in this arrangement, at least three parties are implicated – the owner and right holder who have contracted for the grant of the right and one or more potential third-party buyers, should be to whom the company wishes to offer / sell the shares.[3] In brief, the right of first refusal is akin in concept to a call option. The ROFR can cover almost any sort of assets(s) and is commonly employed in a variety of contractual settings. It is found, among others, in real estate sale, lease contracts, personal property, a patient license, a screenplay, in agreements among shareholders of a closely held company or in an interest in a business. It might also cover business transactions that are not strictly assets, such as the right to enter into a join venture, a distribution agreement or management agreement. For instance, In the entertainment industry, a right of first refusal on a concept or a screenplay would give the holder the right, assumingly, to make that movie first. Only if the holder turns it down, may the owner then shop it around to other parties.

Taking the above into consideration, it may be noted that the aforementioned right is framed so as to enforce the interests of the investors and the promoters/ current shareholders in a particular venture. Considering the same, it would be a futile exercise if the enforceability of the said right is not known to the parties to such agreements.

Pre-Emptive Right – As compared to ROFR, there is an almost similar right which is known as a pre-emptive right. It may not be easy proposition to differentiate between the ROFR and the pre-emptive rights, as the two seem to be similar, if not identical. Contrary to a right of first refusal, a pre-emptive right appears to be similar to a right of first offer. A Right of first offer is a close cousin to the right of the first refusal. Under the right of first offer, before an owner can sell property subject to a right of first offer, the right holder must be given the chance to make an offer for the property. The owner can them either accept the offer; or the owner can sell the property to a third party, but only at a price above the one offered by the right holder. For this right to be effective and enforceable, in the case of private company, the same may be inserted in the Articles of Association of the Company. As per the said right, the right to transfer shares to non-members is restricted. Further, it is worthwhile to note that a private agreement between two or more shareholders in which they impose restrictions upon each other as to their right of transfer does not bind the company and, consequently, the same is likely to be a subject matter of a civil suit between the parties to the agreement and the party committing breach may have to answer in terms of damages to the other. To bind the company, the agreement has to include the company as one of the parties, and it has to be a subject matter in the Articles of Association.[4]


The discussion on this subject began in the year 1992 when the Supreme Court in the case of V.B.Rangaraj v. V.B.Gopalakrishnan[5] held that in case of a private limited company transfer restrictions, if any, agreed by the shareholders unless embodied into the articles of association would not be valid and binding.  On the other hand, the Delhi High Court and the Company Law Board held that in case of listed shares there cannot be any restrictions namely rights of first refusal or any such rights.  This was because Section 111A(2)[6] of the Companies Act 1956, provides that the shares and debentures and any interest therein of a company shall be freely transferable.  Justice Chandrachud of the Bombay High Court also took the same view in 2010 in the case of Western Maharashtra Development Corporation vs. Bajaj Auto Ltd  [7] and observed that the principle of free transferability must be given a broad dimension in order to fulfill 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 into the Companies Act, 1956. 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 preemption 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 preemptive right created by the agreement between the parties. This is impermissible..

This interpretation was causing lot of hardship on the PE investors / Strategic Partners in negotiating the right of first refusal or tag / drag rights with the Promoters, which are typically exit options negotiated to protect their commercial interest.  Question therefore was whether in a listed company one can validly offer right of first refusal or tag/drag along rights that would ultimately be legally enforceable?

The aforesaid decisions came up for consideration before the Division bench of the Bombay High Court in case of Messer Holdings Limited v. Shyam Madanmohan Ruia and Ors [8].  The judgment is interesting as it comes in the wake of the Bombay High Court judgment in Bajaj Auto case[9]; it changed the way to negotiate restriction on transfer of shares in a public company. That judgment had ruled that any pre-emptive rights over shares in public limited companies was illegal in view of the principle of free transferability enshrined in Section 111A of the Companies Act, 1956. The debate on enforceability of terms of shareholder agreements governing public limited companies is definitely not over yet.

The Court with respect rejected the earlier interpretation given to the words free transferable used in section 111A by the single Judge in the Bajaj Auto case[10].   The Division bench for the first time examined the true intent of section 111A, the reason for its insertion in the Companies Act, 1956 and observed that earlier when the shares were in physical form, board of directors used arbitrary powers to reject transfer of shares leading to lot of complaints by the transferees.  That situation was partially remedied by insertion of section 22A of the Securities Contract Regulation Act, which laid down only four grounds on which any board could reject transfers.  With the introduction of the concept of dematerialized shares through the Depositories Act, 1996, section 22A got deleted and section 111A was introduced in the Companies Act to deal with rectification of register.  The Court observed that the whole purpose of section 111A is to regulate the right of the board of directors to refuse transfer of shares. Under Section 111-A, the Company Law Board has been empowered to direct any depository or company to rectify its register or records on an application made to it by a depository, company, participant or investor or SEBI.[11]

Tags: Companies Act 1956Company Law BoardCorporationDelhi High CourtPre-emption rightRight of First RefusalROFRShareholders' agreement

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