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

Current Position in India

Recently on the October 3, 2013 a Notification[12] was issued by SEBI (Securities Exchange Board of India), which said ROFR was legally allowed and valid in the Shareholders Agreement. Also allowed tag along and drag along rights. Through this, SEBI has rescinded its previous notification of March 1, 2000 that prohibited contracts other than spot delivery contracts or those entered into through the stock exchange mechanism. Accordingly, SEBI now permits various types of pre-emption rights and put and call options, but subject to certain conditions. The new position is as follows:

1. Spot delivery contracts are permitted, consistent with the previous position;
2. Sale and purchase contracts on securities are permitted so long as they are in  accordance with securities regulations and stock exchange regulations and by-laws. These would include transactions, including in derivatives, which are carried out through the stock exchange.
3. 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.
4. Put and call options contained in shareholders agreements or articles of association are treated somewhat differently from pre-emption rights discussed in item 3 above. The reason is that the exercise of options is subject to certain conditions:
   1. The underlying securities that are the subject matter of the options must have been held by the relevant party for a minimum period of 1 year from the date of entering into the option contract. This seems to be to ensure that options are not short-term in nature and are permitted only when the holding of the securities is for a considerable period of time. The genesis for the erstwhile prohibition on options was to prevent speculation in securities, and this approach is imposing a minimum 1-year term on the options is consistent with that philosophy.
   2. The pricing of the options and the exercise is to comply with applicable laws. More specifically, the notification states that all contracts permitted through it must comply with the provisions of the Foreign Exchange Management Act, 1999. This applies when options and pre-emption rights are granted by or in favour of a non-resident investor. Where the exercise of the option or pre-emption results in a transfer of securities between a resident and a non-resident investor, then the idea is that the relevant pricing norms imposed by the Reserve Bank of India (RBI) must be complied with. This is significant for foreign investors to take into account. Merely because SEBI has now conditionally permitted options, it does not mean that parties have complete freedom in exercising the options. The pricing is still regulated by the relevant RBI norms, and hence the commercial understanding between the parties regarding the exercise price will be subject to these regulatory constraints.
   3. The new permissible regime applies only to physically-settled options where there is an actual delivery of the underlying securities. It does not cover cash-settled options, which are essentially contracts for differences. This is understandable given the philosophy of the legal regime to curb speculation. Moreover, investment agreements (where investors seek exit rights) usually relate to an actual sale or purchase of securities rather than a contract for differences, and hence this should not pose difficulties for customary investment transactions.
5. This new permissible legal regime applies only prospectively, and does not affect or validate any contract which has been entered into prior to the date of the notification. Hence, past contracts with pre-emption rights or put and call options will not be grandfathered. One possibility to overcome this restriction would be for parties to existing contracts to re-execute them as of a future date.
6. Finally, an explanation to the notification states that the contracts specified in the notification would be valid without regard to anything contained in section 18A[13] of the Securities Contracts (Regulation) Act, 1956, which refers to exchange traded contracts. In other words, such pre-emption rights and option contracts would be permissible even though they are entered into on an over-the-counter (OTC) basis and not traded on the stock exchange.

Overall, SEBI™s notification represents a momentous regulatory change. Companies, investors and their advisors have been grappling with concerns regarding the enforceability of pre-emption rights and options for nearly two decades now. The oddity of the situation was the expansive application of SEBI™s previous regime that applied not only to listed companies but also to unlisted public companies. Moreover, while speculation was the concern, it seemed to encompass genuine transactions as well, making customary investment transactions inefficient in terms of structuring (particularly of exit options).

The current move is welcome as it rectifies a previously ambivalent and restrictive legal regime. This will augur well to investors as well as companies requiring capital. There may very well be issues regarding the specifics of the recent notification and the conditions imposed therein, but the overall development is positive in nature.[14]

Provision under The Companies Act, 1956 

One of the most controversial question raised and still being ambivalent is :

Whether ROFR agreements, Tag along and Drag along rights are enforceable under law and in compliance with section 111A of the Companies Act, 1956?

It is pertinent to highlight that this point is no longer Res integra, but is covered by the decision of the Supreme Court in the celebrated case of V.B.Rangaraj v. V.B.Gopalakrishnan[15], In the said case, the Apex Court has held that a restriction which is not specified in the Articles of Association is not binding either on the Company or on the shareholders. The court further held that the arrangement (as in the said case) imposed additional restrictions on the member™s right of transfer of his shares which were not stipulated in the articles and, therefore, were not binding either on the shareholders or on the company. It was also held that the shares are movable property and transfer thereof is regulated by the articles of association of the Company. The Court held that even if the Articles of Association provide for a ROFR, if the right is a restriction on the free transferability of shares and not a mere process, then it is not likely to be enforceable.

Later the Judicial view point decided in 2010 in the case of Messer Holdings Limited v. Shyam Madanmohan Ruia and Ors.[16], A Division Bench of the Bombay High Court had ruled in this case that a private arrangement between shareholders of a public limited company on a voluntary basis relating to share transfer restrictions (right of first refusal) is not violative of Section 111A of the Companies Act, 1956. 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.

Shareholders can enter into a consensual agreement in case of shares of public companies, can also freely negotiate and enter into agreement containing the ROFR or what is commonly known as Pre-emption/ Tag Along/ Drag Along rights even in the case of listed shares, which was recently confirmed by the Division bench of A.M. Khanwilkar and A.A. Sayed, JJ. of the Bombay High Courts. These Share Purchase Agreement (SPA) are usually assent between the Promoters, PE Investors, Technical or Financial Collaborators.

The decision in the case of Messer Holing provided some relief to shareholders of a public company however not resolved issues and concerns of corporates and joint venture parties. But some questions yet to find their stands. Without a company being a party to the agreement between the shareholders, its terms cannot be inserted in to Articles and even in case its incorporated in the Articles, the validity of restriction on share transfer in a public company would not be sustained and uphold looking the decisions delivered so far. In such circumstances, since shareholders agreement is not biding to a Company, a shareholder cannot restrict the company from transferring shares which is in violation of the agreement. Unless and until the role of the company and such restrictions validly find the place in Articles, Company Law Board would not have jurisdiction for civil breach. Therefore remedy available for aggrieved shareholder is to approach civil court, which is costly and lengthy and many times parties reluctant to prefer it in joint venture business[17]. An in-depth analysis of the aforementioned case is required as it is the most recent decision on the point in issue.

Messer Holdings Limited v. Shyam Madanmohan Ruia and Ors. [18]

In Messer Holdings, as is well-known, clause 6.1 of the SPA dated June 23, 1997 between the parties conferred a right of first refusal on the Ruias in respect of the shares of Bombay Oxygen Ltd., unless the shares were to be sold to a member of the Hoechst group of companies.

The controlling shareholders of Bombay Oxygen Ltd, a public listed company agreed to divest a majority of their shareholding to Messer Griesheim Gmbh (MGG) pursuant to which the controlling shareholders agreed to divest a majority of their shareholding in the Company to MGG. As per Clause 6.1, in the event either party intended to sell the entire or any part of the shares in the Company, the transferring party was required to first offer the shares being transferred to the other party. Although this case dealt with various other issues, we analyze the issue pertaining to the legality of Clause 6.1 of the SPA and whether the same is violative of free transferability of shares in a public company provided by Section 111 A of the Act. MGG relied on inter-alia the decision of the Single Bench in Bajaj Auto Ltd[19] where this Court held that pre-emptive rights on shares of a public company are contrary to the provisions of Section 111A of the Act which requires that the shares of a public company should be freely transferable.

The Division Bench however, over ruling the aforesaid judgment, held that such private arrangements are not in violation of Section 111A of the Act in a pubic company in reliance of the following:

• Section 111A of the Companies Act, 1956, is perhaps the most significant unresolved controversy in contemporary Indian Corporate Law. Section 111A of the Companies writes that ..Subject to the provisions of this section, the shares or debentures and any interest therein of a company shall be freely transferable…. The section speaks about free transferability of the shares and debentures of the Public Limited Company.

• Given the historical background of the deletion of Section 22A of the Securities Contracts (Regulations) Act, 1956 (SCRA) by the Depositories Act, 1996 and the introduction of Section 111A in the Act, it can be inferred that the provisions of Section 111A was meant to regulate the powers of the board of directors of a company qua the transfer of shares or debentures of a company and any interest therein. The board of directors cannot refuse to register a transfer of shares unless there is sufficient cause to do so.

• Section 111A of the Act is not a law dealing with the right of the shareholders and does not expressly restrict or take away the right of shareholders to enter into consensual arrangement/agreement by way of pledge, preemption/sale or otherwise. The expression freely transferable in Section 111A of the Act does not mean that the shareholder cannot enter into consensual arrangements/agreement with the third party (proposed transferee) in relation to his 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 an obligation on the shareholder to sell his shares.

• Reliance was also placed on Section 9 of the Companies Act, 1956 which stipulates that provisions of the Act shall have the effect notwithstanding anything to the contrary contained in the Memorandum or Articles of the Association.

• The decision in M.S.Madhusoodhanan v Kerela Kamaudi pvt. Ltd.[20] is an authority on the proposition that consensual agreements between particular shareholders relating to their specific shares do not impose restriction on the transferability of shares. Further, such consensual agreements between particular shareholders relating to their shares can be enforced like any other agreements. It was not required to be embodied in the Articles of Association.  The Division Bench also relied on the distinction drawn by the Supreme Court in Madhusoodhanan[21] from the proposition laid down in the case of V.B Rangaraj[22], in that the judgment arrived at by the Supreme Court was on account of the restriction being a blanket restriction on all the shareholders present and future and could not be imported to a private agreement between particular shareholders.

The Defendant too relied on a few judgments but it was also observed by the Learned Single Judge that the dictum in the relied decisions were of no avail as the case on hand was in relation to a public company whereas the decisions in those respective judgments are in concern with the Private Company under which the transferability of shares in restricted. It is held that in case of public company, Section 111A provides that the shares or debentures and any interest therein of the company shall be freely transferable.

As aforesaid, Section 111A is not a law dealing with the right of the shareholders to enter into consensual arrangement/agreement by way of pledge, preemption/sale or otherwise. If that right is not covered by Section 111A of the Act as has been found by us, then consensual arrangement/agreement between shareholder and third party or shareholders inter se to which company is not a party, Section 9 of the Act will not come into play at all. Thus, the 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.[23]

In my view :

(a) This division bench has gone into the intent of 111A. The division bench has rightly held now that when shares are freely transferable doesn™t mean that the shareholders lose the right to dispose off or deal with the shares in the manner in which they like.

(b) The Bench has explained the intent that the section 111A was never incorporated to take away the rights of the shareholders to dispose, which is one of the rights enjoyed by any owner of any movable property. ROFR and other such agreements are important exit provisions for any financial or strategic investor.

(c) This may not be the last word because this controversy may knock the doors of the Supreme court, but certainly it™s a division bench judgment and is the only judgment in the case of a public companies of 111 (A) therefore in that sense it certainly it sets aside the controversy which was raised right from the beginning of Rangarajan from 1992.