Restrictions on Transferability of Shares and the Right of Pre-Emption

RESTRICTIONS ON TRANSFERABILITY OF SHARES AND THE RIGHT OF PRE-EMPTION

-Raghavi Viswanath

INTRODUCTION

The distinction between private and public companies is primarily based on the idea that the legislation intends to make available the advantages of corporate trading to private traders or private persons. These advantages are embodied in the form of privileges which are given to private companies by the Companies Act. The principal advantage of private companies which are usually family concerns is to secure absolute secrecy as regards their affairs and at the same time to have the liability of their members limited either by shares or by guarantee. It should be borne in mind that the main characteristic of a private company which is limited by shares, is that it cannot invite the public to subscribe to its shares or accept deposits from the public. Usually all its shares are held by a few persons who are, more often than not, members of the same family.[1]

Section 2(68) of the Companies Act, 2013 defines a Private Company as: “Private company means a company which by its articles,-

• restricts the right to transfer its shares, if any;
• limits the number of its members to fifty not including –

(i) persons who are in the employment of the company; and

(ii) persons who, having been formerly in the employment of the company, were members of the company while in that employment and have continued to be members after the employment ceased; and

(c)  prohibits any invitation to the public to subscribe for any shares in, or debentures

of the company;

Provided that where two or more persons hold one or more shares in a company jointly, they shall, for the purposes of this definition, be treated as a single member.

Further the Companies (Amendment) Act, 2000 made the following major amendments to the Act of 1956:

(1) Private Companies and Public Companies to have a minimum paid-up capital of Rupees one lakh and five lakh respectively.

(2) Change of place of registered office from the jurisdiction of one Registrar of Companies to another Registrar of Companies within the same state requires confirmation from the Regional Director.

(3) Provisions relating to deemed public companies became inoperative and a new provision relating to conversion of a public company to a private company inserted by the 1956 Act.

By virtue of the Companies (Amendment) Act of 25^th May, 2015, the requirement of minimum paid-up capital was also done away with in Companies Act, 2013. It is however interesting to note that the Act does not specify any particular form of restriction or prescribe the maximum extent or scope of the restriction required. Thus the restrictions may be as slight or as severe as the framers of the articles desire. The statute merely requires that the articles of a private company limited by shares must contain restrictions on the transfer of shares. Such restrictions should be general and apply uniformly to all the shareholders and to all types of shares[2]. They should not exempt certain shareholders or a certain class of shares.

TRANSFER OF SHARES

Palmer has elucidated the philosophy of transfer of shares in the following words: “It is well settled that unless the articles provide otherwise the shareholder has a free right to transfer to whom he will. It is not necessary to seek in the articles for a power to transfer for the Act itself gives such a power. It is only necessary to look to the articles to ascertain the restrictions, if any, upon it. Thus a member has a right to transfer his shares to another person unless this right is clearly taken away by the articles”.[3]

Transfer of shares is the voluntary conveyance of the rights and possibly the duties of a member as represented in a share in the company from a shareholder who wishes to cease to be a member to a person desirous of becoming a member.[4] Thus simply a transfer of shares means a change in the ownership of the shares by the voluntary act of the parties. Transmission of shares as distinct from a transfer of shares occurs when a change of ownership in the shares takes place, not by agreement and the voluntary action of the parties, but by the operation of the law and as a result of some other event, such as the death or insolvency of the shareholder as under Section 56 of the 2013 Act.[5]

In a contract for transfer of shares the following are usually the implied terms:

• That the transferee will pay the price and that the transferor will hand over to him genuine instruments of transfer and share certificates
• That the share certificate carries the rights and interests which it purports to convey
• That there is no undertaking by the transferor that the transferee will be registered
• That the transferor will do nothing to prevent the transferee from having the transfer registered or to delay that event
• That the transferee will indemnify the transferor from any calls or liability which may arise in respect of the shares subsequent to the transfer

These terms are usually implied in a contract providing for transfer of shares and they may be nullified by clauses which have been expressly stated in the contract.

Once the contract has been entered into the transferee has an equitable title to the shares and the transferor holds them, until registration, as trustee for the transferee. However until the purchase price is fully paid the seller remaining on the register is entitled vis-à-vis the purchaser to vote in respect of the shares without respect to the wishes of the purchaser.[6]

NEED FOR RESTRICTIONS ON THE TRANSFER OF SHARES

In the USA, Private Companies are referred to as ‘Close Corporations’.[7] This term implies that private companies are closely knit family or friendly affairs. The members of a private company are connected by bonds of kinship, friendship or similar close ties and the intrusion of a stranger as a shareholder would be felt to be undesirable unless his admission is accepted by the existing members. Some private companies are in fact so constructed so as to amount to in economic terms as nothing more than incorporated partnerships with extremely close ties between the members. Thus these restrictions are needed in order to preserve the soul of the private company ie. the partnership principle. These restrictions on transfer of shares prevent anybody or everybody from acquiring shares of the company by transfer and help to keep the close ties amongst the members intact.

DIFFERENCES BETWEEN RESTRICTION AND PROHIBITION

As per section 58(2), the securities or other interest of any member in a public company shall be freely transferable. However, any contract or arrangement between two or more persons in respect of transfer of securities shall be enforceable as a contract. It is also important to see that these restrictions are not construed as a ban or a prohibition on the transfer of shares. The Courts have consistently held that the restriction upon transfer means any restriction that will give some control to the company over transferability of shares[8]. It does not mean a prohibition on the transfer of shares. It was held in Chiranji Lal Jasrasaria v. Mahabir Dhelia[9] that a restriction which amounts to a prohibition on transfer of shares or which precludes a shareholder altogether from transferring is invalid. Moreover a prohibition on the transfer of shares will amount to violation of Section 58 of the Companies Act, 2013 and Section 6 of the Transfer of Property Act, 1872. Therefore if a clause in the articles provides that shares are not transferable but heritable, it will be valid. This is because: Shares are property and under Section 6 of the Transfer of Property Act, 1872 prohibiting transfer of property is not allowed. Transferability is the general nature of property and even when there is a restriction on transfer, when the person dies the restriction will not apply.

STRICT CONSTRUCTION OF RESTRICTIONS

Lord Greene MR in Smith and Fawcett Ltd., Re[10] stated that “In construing the relevant provisions in the articles it is to be borne in mind that one of the normal rights of a shareholder is the right to deal freely with his property and to transfer it to whomsoever he pleases and this right is not to be cut down by uncertain language or doubtful implications”. Any limitation on the right of transfer must be strictly complied with. Thus as the restrictions on transfer of shares are strictly construed and wherever a certain restriction can be interpreted in several ways the narrower construction will be adopted the framers of the articles must be extremely careful in drafting the restrictions on the transfer of shares so as to prevent any injustice to the shareholders.[11] The courts should not always literally interpret the restrictions as sometimes a literal interpretation of these restrictions can defeat the very purpose of the restrictions contained in the articles.

 

THE JUDICIAL STAND ON RESTRICTIONS ON TRANSFERABILITY

Section 111A, which was the operative dealing with free transferability of shares of a public company in the erstwhile Act was extensively interpreted and discussed by Indian Courts. This can be observed by the following judgments:

• In the case of SP Jain v. Kalinga Tubes,[12] the Court held that when the terms are not incorporated in the Articles of Association, such restrictive terms would be void and   unenforceable on the company.

 

• The Supreme Court in 1992 in its decision in V.B. Rangaraj v. V.B. Gopalakrishnan[13]; held that a restriction on the transfer of shares contrary to the articles of association of a private company was not binding on the private company or its shareholders.

It elucidated that shares are movable property and their transfer is regulated by the Articles of Association of the company. The Articles of Association are the regulations of the company binding on the company and its shareholders. Therefore, the only permissible restrictions on the transfer of shares are those which are contained in the Articles of Association. An additional restriction not contained in the articles but in a private agreement between two shareholders which places further obstacles in the way of transferability is not binding either on the company or on the shareholders.  The vendee of the shares cannot be denied the registration of the shares purchased by him on a ground other than stated in the Articles.

• The Gujarat High Court in 1998 in its decision in Mafatlal Industries Ltd., v. Gujarat Gas Co. Ltd[14] relying on the Supreme Court’s decision in V.B Rangaraj, did not enforce the pre-emptive rights of the shareholders of a public company as the same were not incorporated Articles of association of the said public company.

 

• However, this position was amended in the 2003 Supreme Court decision in Madhusoodhan v. Kerala Kaumudi[15] wherein the Court did not disagree with the decision in V.B Rangaraj but distinguished itself from the facts in that judgment and held that a restriction in relation to identified members on identified shares of a private company did not amount to restriction of transferability of shares per se.

 

• The Delhi High Court in 2005 in its decision in Pushpa Katoch v. Manu Maharani Hotels Limited[16] held that as per the provisions of Section 111A of the Act, there could not be any fetters on the right of a shareholder to transfer his/her shares in a public company and observed that a right of pre-emption, even if found in the articles of association, would be ultra vires the provisions of the Act. This was reiterated in the Jer Rutton Kavasmanek case,[17] though however this case has been severely criticized for taking into account the legislative history of transferability of shares before disagreeing with the Madhusoodhan case.[18]

 

• The Single Bench of the Court in 2010 in its recent decision in Western Maharashtra Development Corporation Ltd. v. Bajaj Auto Ltd[19] , in relying on the decision of the Delhi High Court in Pushpa Katoch held that pre-emptive rights over shares in a public company are a fetter on the transferability of such shares and therefore patently illegal.

 

The judicial position on transferability of shares of a private company was crystallized by the decision of the Bombay Division Bench in 2010 in the case of Messrs Holding v. Shyam Madanmohan Ruia.[20] This has been translated by the legislators into the proviso to Section 58(2) which states that contracts or agreements entered into by shareholders shall be enforceable as contracts and binding only upon the shareholders.

The interpretation by the Division Bench of the term “freely transferable” appears to be a complete contradiction to the interpretation arrived at by the Single Bench in the Bajaj Auto case. Although the Division Bench appears to have given the term transferability a liberal meaning, it is important to decipher as to whether all forms of private arrangements can take refuge of this judgment and be upheld as legal. Although the Division Bench has in this judgment given a broad dimension to the term freely transferable as set out in Section 111A of the Act, it has also stated that 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 to another party with right of first purchase at the prevailing market price. Freedom to purchase cannot mean obligation on the shareholder to sell his shares.

The Division Bench in Messrs Holdings has also questioned the necessity of amending the articles of association of a public company to include such transfer restrictions. In fact the Division Bench has specifically stated that such consensual agreements between particular shareholders relating to their shares can be enforced like any other agreements and it is not required for such arrangement to be embodied in the Articles of Association.

Recently, in the obiter to the Vodafone case,[21] K.S.P. Radhakrishnan, J. has suggested obiter that Rangaraj may have been wrongly decided because it imposes a fetter on the freedom of the parties to enter into contract although no such fetter is found in Companies Act, 1956.

TYPES OF RESTRICTIONS

Restrictions on the rights of shareholders to transfer their shares generally take two common forms:[22]

1. Right of Pre-emption in favour of the other members
2. Powers of the Board of Directors to refuse to register transfer of shares

PRE-EMPTION CLAUSE

In Bishan Singh v. Khazan Singh[23] the Court stated that the right of pre-emption is not a right to the thing sold but a right to the offer of a thing to be sold. The most common type of transfer restriction is the right of pre-emption. The pre-emption clause in the articles generally provides that when a member wishes to sell some or all of his shares, he shall first offer them to the other members for purchase at a price ascertained in accordance with a formula set out in the articles, or at a fair price at which the shares are valued by the directors or by the company’s auditors and he shall transfer the shares to his proposed transferee only if the other members do not exercise their right of pre-emption. The pre-emption clause goes a long way in ensuring that the control of the shares does not fall into the hands of undesirable persons as it ensures that the existing shareholders get the opportunity to buy the shares first.

Various types of pre-emption clauses are found in the articles of private companies. Sometimes it is provided that the proposing transferor shall offer the shares first to all other shareholders rateably; sometimes he is entitled to select the shareholder to whom he wants to sell; sometimes the first offer has to be made to certain shareholders e.g. those holding founder’s shares; sometimes the articles provide that in certain circumstances e.g. in the case of death of a member, the surviving members or directors are obliged to acquire the deceased member’s shares. It is usual to supplement these pre-emption clauses with the general restriction clause by providing, for example, that after the failure of those entitled to pre-emptive rights to acquire the shares and after their subsequent offer to another person, the directors may decline the transfer[24]. There is no doubt as to the validity of these pre-emption clauses and courts have consistently upheld the validity of the pre-emption clause in the article of a private company.[25]

The pre-emptive clause is brought into operation where shareholders agree to sell the shares, receive the purchase price and retain it.[26] Where the pre-emption clause provides-as is normally the case- that a share may be transferred to any member but shall not be transferred to a person who is not a member so long as any member is willing to purchase the same at the fair value, the transfer between members is completely unrestricted and does not bring into operation the provisions of the pre-emption clause.[27] Rights of pre-emption manifest in the form of rights of first refusal, tag-along rights, drag along rights and put options.

IMPLEMENTATION OF PRE-EMPTIVE RIGHTS

Where the articles provide a procedure for implementation of pre-emptive rights the procedure laid down has to be followed. The procedure that is usually laid down in the articles is to require the transferor to give to the company a notice of his intention to transfer his holding and asking the company to notify the other members of the availability of the shares and the price at which they will be available to them for acquisition and the time within which they should communicate to the company their desire to purchase the proffered shares. When the articles do not provide any machinery for implementation of pre-emption rights the member who wants to transfer his shares must notify all the members of his intention to do so. He should then allow them a reasonable time to inform him of their decision.

A member cannot evade a provision for pre-emption in the articles by contracting to sell his shares to a third person or by executing an instrument of transfer to such a person, with the intention that the purchaser shall not apply for registration as a member, but shall rest content with the vendor holding the legal title to the shares as a bare trustee for him[28]. It has been held that a pre-emption provision was complied with where one member sold to another member even though the purchase price was paid by an outsider and the transferee was to vote at the outsider’s discretion[29]. It is humbly submitted that the decision of the Court to recognize this as a valid transfer and to hold it in compliance with the pre-emptive clause is erroneous as the decision goes against the very objective of the pre-emptive clause ie. to prevent outsiders and undesirable persons from gaining control of the company. In this case although the pre-emptive provision was complied with in form it was violated in substance. The court should have looked at the substance of the matter and not the form.

TRANSFERS CONTRAVENING PRE-EMPTIVE CLAUSE

A company can reject a transfer contravening the provisions of the company’s articles, but the company can waive its right and accept a contravening transfer and once it does so, it loses the right to question the validity of the transfer. Hence, a transfer contravening the articles is not a nullity or void ab initio[30]. In Tett v. Phoenix Property and Investment Company Limited[31] Justice Vinelott held that “despite the disregard of the preemptive provisions there had occurred a complete and effective transfer between transferor and transferee in terms of which the equitable title passed to the latter”. In this case the shares in question were sold to an outsider and a transfer deed was executed in his favour in complete disregard to the pre-emptive provisions. Some shareholders were interested in acquiring the shares but not at the price which the outsider was willing to pay. The Court of Appeal held that the transfer was in violation of the pre-emptive provisions and the company was not compelled to accept it. The decision of the court is praiseworthy as it recognizes the true objective of the pre-emptive clause and preserves the partnership principle in the private company. The privacy of a close corporation is more important than the price offered by an outsider, however great such a price may be. A different decision by the Court of Appeal would have defeated the intention of the incorporators when they formed the company.

RECENT DEVELOPMENTS

It has also been noted that the Balco Arbitration[32] has ruled that a call option is illegal vide Section 111-A, despite the Messrs Holdings case; and the Securities Appellate Tribunal (SAT) in Sahara case[33] has observed in passing that a condition in the OFCD application form that the approval of the company is necessary for a transfer thereof may be contrary to Sections 82 and 111-A( pari materia to Section 58(2) of the 2013 Act). In short, there are now two limitations operating on a pre-emption clause or other contractual restrictions on transfer: the incorporation rule applying across the Board, and the free transferability rule applying to public companies.

In Surat Electricity Co. Ltd. v. Union of India,[34] the Bombay High Court held that the expression “freely transferable” was not merely declaratory and explained its scope in the following terms: What it seeks, in effect, to lay down is that except in cases of refusal of registration of transfers, in all other cases of transfers, there would not be any restrictions on transferability of the securities of the listed companies and the Boards of such companies shall have no power to refuse to register transfer of the securities. Obviously, the articles of association of such companies cannot impose restrictions on transfer nor can they confer upon the Board power to refuse registration on the grounds specified in the articles or on any other ground whatsoever, and even though they do so, that would be ineffective.

However, this position has seen significant change after the enactment of the new Companies Act with the proviso to Section 58(2). Furthermore,  the Securities Exchange Board of India released a notification on 3^rd October, 2013[ under Section 16 and 23 of Securities Contracts ( Regulations) Act, 1956][35] rescinding its 2000 notification as a result of which “Contracts for pre-emption including right of first refusal (ROFR) or tag-along or drag-along rights contained in shareholders agreements or articles of association are allowed. Note that this is only an inclusive provision and is not exhaustive of all the types of provisions in the agreements or articles that can be enforced. This enables investors to exercise their exit rights in companies through the above mechanisms that are generally recognized. No conditions are attached for the exercise of these rights.” This notification was an implementation of the Law Ministry’s recommendation to permit options in investment agreements.[36]

CONCLUSION

It is worth observing that a legislative solution, in order to be comprehensive, must not only provide that an agreement between shareholders is not ineffective simply because it is not reflected in the articles of association, but also that free transferability is no bar to the validity of contractual arrangements (that voluntarily impose restrictions on transfer of shares). The former would of course apply across the Board, and the latter to public companies. It is apparent that Section 58 does not address the former situation at all, and only partially achieves the latter. For one, sub-section (1) deals only with private companies, and sub-section (2) opens with the words “without prejudice to subsection (1)”. The necessity for this qualification is not obvious, and perhaps the legislature wishes to make it abundantly clear that the shares of private companies are not freely transferable. However, the difficulty arises because the provision that is intended to save contractual arrangements operates as a proviso to this sub-section (and therefore as a proviso to the words without prejudice. As a result, although the proviso to Section 58(2) may have the effect of protecting contractual arrangements in respect of public companies from attack on the ground of free transferability, it may also be suggested that the legislature has indirectly affirmed (or at least refrained from reversing) the incorporation rule in Rangaraj. Although the better view is that any such suggestion would be unfounded, it is unfortunate that the legislature has left the door open for that ambiguity. Secondly, the proviso to subsection (2) of Section 58 can in any event have no bearing on Rangaraj rule, because it: (i) applies only in respect of public companies, and (ii) it is a settled principle of law that a proviso is an exception to the main section and not to other provisions. As a result, Section 58(2) affirms Rangaraj, either a contractual restriction in respect of the shares of any company will be ineffective unless it is incorporated in the articles of association, or such a restriction in respect of a public company will be enforceable as a contract under the proviso to Section 58(2), but exactly the same restriction in respect of the shares of a private company will be unenforceable even as a matter of contract.

 

[1] A.L Saha, Lectures on Company Law (Bombay: N.M Tripathi Private Limited, 1990).

[2] A.K Majumdar and Dr. G.K Kapoor, Company Law and Practice (New Delhi: Taxmann Publications Limited, 2000).

[3] N.Vijia Kumar, Transfer of Shares, SEBI and Corporate Laws Vol. 35 (2002).

[4] Vyapak Desai, Right of First Refusal: Is it valid in law?, India Law Journal, Vol. 4, 2013.

[5] B.K Sen Gupta, Company Law (New Delhi: Eastern Law House, 1990) at 181.

[6] Clive M. Schmitthoff, Palmer’s Company Law Vol. I (London: Steven and Sons Limited, 1976).

[7] Richard W. Jennings and Richard M. Buxbaum, Corporations- Cases and Materials ( Minnesota: West Publishing Company, 1979) at 367.

[8] A. Ramaiya, Guide to the Companies Act Part I 14^th ed. (New Delhi: Wadhwa and Company Law Publishers, 1998) at 73.

[9] AIR 1966 Assam 48.

[10] [1942]1 All ER 542.

[11] Paul L. Davies, Gower’s Principles of Modern Company Law (London: Sweet and Maxwell Limited, 1997).

[12] AIR 1965 SC 1535.

[13] (1992)1 SCC 160.

[14] (1999) 97 Comp Cas 301 (Guj).

[15] (2004) 9 SCC 204.

[16] Pushpa Katoch v. Manu Maharani Hotels Ltd., (2006) 131 Comp Cas 42 (Del).

[17] J.R. Kavasmanek v. Gharda Chemicals Ltd., (2011) 166 Comp Cas 377 (Bom).

[18] Umakanth Varottil & V. Niranjan, Enforceability of Contractual restrictions on transfer of shares, SCC Journal Section at (2012) 5 SCC J-1.

[19] (2010) 154 Comp Cas 593 (Bom) at paras 57-58.

[20] (2010) 159 Comp Cas 29 (Bom).

[21] Vodafone International Holdings B.V. v. Union of India, Civil Appeal No. 733 of 2012, order dated 20-1-2012 (SC).

[22] Robert R. Pennington, Company Law (London: Butterworths, 1990) at 752.

[23] 1959 SCR 878.

[24] Clive M. Schmitthoff, Palmer’s Company Law Vol. I (London: Steven and Sons Limited, 1976).

[25] In Ontario Jockey Club v. Samuel Mcbridge, AIR 1928 PC 291 the Court held that “A restriction which precludes a shareholder altogether from transferring may be invalid, but a restriction which does no more than give a right of pre-emption is valid”.

[26] Lyle and Scott Ltd. v. Scott’s Trustee, [1959]2 All ER 661.

[27] Greenhalgh v. Mallard, [1943] 2 All ER 234.

[28] Lyle and Scott Limited v. Scott’s Trustees, [1959]2 All ER 661.

[29] Theakston v. London Trust Plc., (1984) BCLC 390.

[30] Hunter v. Hunter, 1936 AC 222 HL.

[31] (1984) BCLC 599.

[32] (2010) 159 Comp Cas 29 (Bom).

[33] Sahara India Real Estate Corpn. Ltd. v. Securities and Exchange Board of India, Appeal No. 131 of 2011, order dated 18-10-2011,

[34] AIR 1995 Bom 377.

[35] http://www.sebi.gov.in/cms/sebi_data/attachdocs/1380791858733.pdf

[36] http://indiatoday.intoday.in/story/cash-flow-fdi-private-equity-funds-for-shareholding-in-indian-companies/1/271302.html