SHARE SC

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Section 111-A v. Shareholders’ Agreement: Finally at Rest? The scheme of Indian company law envisages two classes of companies based on their shareholding: private and public. The former has been defined to mean a company which, by its Articles of Association inter alia restricts the rights of its members to transfer its shares, restricts its total number of members to 50 (fifty) and prohibits any invitation to the public to subscribe to its shares or debentures. The latter is defined as a company which is not a private company. The necessary inference that follows is that a public company is one which inter alia does not restrict the rights of its members to transfer shares. This inference read with Section 111-A of the Companies Act, 1956 (the Companies Act) gives rise to the debate on whether restrictions, by private arrangements or otherwise, on the free transferability of shares of a public company, are enforceable. Relevance of the issue The documents involved in a private equity investment or a joint venture transaction include a share purchase agreement/share subscription agreement along with a shareholders’ agreement. While infusing capital into a company, an investor would want to alter the balance of rights afforded to shareholders under the Companies Act hence, the need for having a shareholders’ agreement to which the investee company is a party. It is also common practice to alter the Articles of Association of the investee company to reflect the position in the shareholders’ agreement. This helps ensure that none of the provisions of the shareholders’ agreement are rendered inoperative by virtue of them being contrary to the constitutional documents of the investee company. Private equity and joint venture transactions are of course more recent instances of such arrangements in India, which were earlier characterised by family arrangements premised on the need to ensure that the shareholding remained in the family. Corporatisation of the company is an outcome of the economic liberalisation of the Indian economy since 1991. And it is in these transactions where unfamiliar parties got together that there was felt a need for comfort in terms of the strategies of the other, whether the promoters whom the investor/venture partner agreed with will remain in the company, continue to bring value to it, or not sell out to persons the other party does not know. Rights affecting the free transferability of shares An investor infusing a considerable capital in a company needs to be convinced of the stability of its commercial operations and the continuing patronage of its existing shareholders because of whom this investor trusts in the commercial viability of the company. On the other hand, the investee company would need assurance that it is not divesting its stake to a fly-by-night investor or that the said investor will not transfer the stake to the company’s competitor or other persons the investee company and its shareholders are uncomfortable with. These and other commercial justifications make it necessary to restrict the free transferability of shares of the investee company. Usually, the following rights (affecting free transferability of shares) are contained in a shareholders’ agreement to protect the interests of either or both parties: - Right of first refusal: a pre-emptive right is given to the non-selling shareholder to receive an offer to purchase the shares at a certain price proposed to be sold by the selling shareholder to any third party. An exception is usually carved out in the case of transfer of shares to affiliates or group companies of the selling shareholder. Upon refusal of the nonselling shareholder to purchase the shares, the selling shareholder is free to sell the shares to any third party but usually not at terms more favourable than those that were offered to the non-selling shareholder. - Right of first offer: the selling shareholder is bound to enter into good faith negotiations with the non-selling shareholder when the former proposes to divest its stake in the investee company. In such a case, the latter has the right to make an offer to buy the shares. If the selling shareholder refuses the offer, it can sell the shares to any third party (not being an affiliate or group company) but not at terms less favourable than those offered by the non-selling shareholder. - Tag Along Rights: the non-selling shareholder has a right which may be exercised as an alternative to the right of first refusal where the selling shareholder is divesting a controlling stake in the Company, where the agreement contemplates such a right. Instead of purchasing the shares offered by the selling shareholder, the non-selling shareholder has a right to sell its shares along with the shares of the selling shareholder and on the same terms as those of selling shareholder. It is typical for an investor having a minority stake in an entity to want to have such an exit option in the event the majority shareholder(s) is divesting its entire or substantial holding in the investee company. To clarify, this right is also often independent of any right of first offer or refusal. - Drag Along Rights: such a clause in the shareholders’ agreement is in the interest of the majority shareholder(s). In the event the selling shareholder is divesting a controlling stake in the investee company, it has the right to compel the non-selling shareholder to sell its shares on the same terms as its own shares. Commercially, such a right enables the selling shareholder to negotiate more favourable terms from the purchaser than it could have with the non-selling shareholder continuing as such in the investee company. - These rights and obligations are legally recognised when the investee company is a private company however, it is important to test their enforceability in case of public companies owing to the direction that the jurisprudence on the subject has taken in India. Rights associated with the ownership of shares Prior to examining the provisions of the Companies Act with respect to transferability, it would be pertinent to examine the concepts of a “share” and the rights associated with ownership of the same. The Companies Act in Section 2(46) defines “share” as a share in the share capital of the company and includes a stock. The real concept of the term “share” http://www.supremecourtcases.com

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has been laid down in Borland’s Trustee v. Steel Bros. & Co. Ltd.1 wherein it has been laid down that a share is not a sum of money but an interest measured by a sum of money and made up of various rights contained in the contract2. Ownership, on the other hand, is the state or fact of exclusive rights and control over a tangible or an intangible property. An owner of property is he who owns a right to the aggregate of its uses. Ownership denotes the relation between a person and a property which forms the subject-matter of his ownership. It contains in a complex of rights, all of which are rights in rem and not merely rights in personam. Ownership entails rights in the property to the owner to possess the property, to use and enjoy the property, to consume, destroy or alienate the property. Further, ownership has a residuary character3. In other words, the right to assign, lease, mortgage and transfer a property lies with the owner himself. Also, ownership affords the owner all those rights in relation to the owned property that are not held by anyone else. It is submitted that the right to transfer a property “at will” necessarily includes with it the right NOT to transfer the said property at will or the right to pre-empt the transfer of the property. Unless the owner has the right to refuse transfer of his property, it is obvious that he will not be in a position to exercise his right to transfer the property to whom he wishes or in the manner he wishes (i.e. whether by lease, sale or otherwise). The shareholders of public companies have the right to freely transfer their shares. Based on the above, would this right entail the right to pre-empt the transfer of the shares by acceding to shareholders’ agreements containing rights such as the right of first refusal, tag along and drag along rights? Section 111-A of the Companies Act Section 111-A(2) of the Companies Act states as under: 111-A. (2) Subject to the provisions of this section, the shares or debentures and any interest therein of a company shall be freely transferable: Provided that if a company without sufficient cause refuses to register transfer of shares within two months from the date on which the instrument of transfer or the intimation of transfer, as the case may be, is delivered to the company, the transferee may appeal to the Tribunal and it shall direct such company to register the transfer of shares. (emphasis supplied) Section 111-A(1) excludes the applicability of the section to private companies. Therefore, it necessarily follows that the shares and debentures of a company should be freely transferable. Law relating to transferability: History and Development The insertion of Section 111-A was brought about by the Depositories Act, 1996 (the Depositories Act). At the same time, Section 22-A of the Securities Contracts (Regulation) Act, 1956 (SCRA), which contained the grounds on which registration of transfer could be refused, was deleted. Section 22-A was introduced in 1985 prior to which the transferability of shares of listed companies was governed by the listing agreement. The object behind the enactment of Section 22-A was ensuring the free transferability of shares and restricting the arbitrary powers of the Board of Directors for refusing registration of share transfers. 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 SEBI4. It may be noted from the above that Section 111-A was introduced in the Companies Act not by way of an amendment in the legislation itself but by the Depositories Act. As per the long title of the Depositories Act, it is an Act, “to provide for regulation of depositories in securities and for matters connected therewith or incidental thereto”. Further, although the Companies Act was enacted in the year 1956, it is unlikely that the free transferability of shares of public companies was emphasised only in the year 1995. The concept of free transferability of shares is inherent in the very definitions of public and private companies as has been explained above. The above should make it clear that the rationale for enactment of Section 111-A was not one of emphasising the free transferability of shares of public companies but one of facilitating transfer of shares in dematerialised form and providing a mechanism to check the misuse of power of the Board of Directors to refuse registration of transfers without “sufficient cause”. Judicial pronouncements on the issue We shall now proceed to trace the history of judicial interpretations on the issue of enforceability of shareholders’ agreements vis-à-vis company law: Shanti Prasad Jain v. Kalinga Tubes Ltd. 5 In this case, an agreement was entered into between two shareholders of a private company and an outsider relating to allotment of new shares in the Company. The Company was not a party to the said agreement and neither were its terms incorporated in the articles of the Company. The Company was subsequently converted into a public company and its articles were amended. However, the articles still did not reflect the terms of the agreement. As per the terms of the agreement, an allotment of shares was to be made to the outsider. However, the Supreme Court precluded the said outsider from enforcing the allotment as he was not a shareholder of the company at the time of execution of the said agreement and neither was the company party to the agreement. It is to be noted that the judgment did not in any way hold that the transfer of shares agreed to between the shareholders inter se http://www.supremecourtcases.com

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did not bind them. V.B. Rangaraj v. V.B. Gopalakrishnan6 In this case, there was an oral agreement between the heads of two branches of a family to the effect that the branches would always hold equal number of shares in a private company and in the event a member of a branch wished to alienate his shares, he would first have to offer the same to other members of the same branch. The Apex Court held that the only restrictions enforceable on the transferability of shares would be those that are contained in the articles of association of a company and for the same reason, the agreement was not enforced. It may be noted that this judgment pertains to a private company. M.S. Madhusoodhanan v. Kerala Kaumudi (P) Ltd.7 In this case, the Apex Court distinguished from the judgment in Rangaraj case8, stating that there was a clear distinction between allotment of new shares by a company and transfer of shares between shareholders. While in the former case, it is the company who actually issues the shares, the role of the company in the latter comes only at the time of recognition of the transferee as a new shareholder. Therefore, while in the first case, it is essential for the company to be part of an agreement to allot shares, it is not so in the second case. While in Rangaraj case9 the restriction was on the right of all the shareholders, present and future, in this case, the agreement was merely between particular shareholders, which imposed a restriction on the transferability of their shares. In such a case, the company need not be a party to the agreement for it to be enforceable. Pushpa Katoch v. Manu Maharani Hotels Ltd. 10 The Delhi High Court, in this case, followed the Supreme Court’s decision in Rangaraj case11 inasmuch as the violation of the right of pre-emption contained in the family settlement was not enforced as the same was not recognised by the articles of association of the company. Western Maharashtra Development Corpn. Ltd. v. Bajaj Auto Ltd. 12 Earlier this year, a Single Judge Bench of the Bombay High Court had also pronounced a judgment on the enforceability of a right of first refusal clause in a shareholders’ agreement. The High Court examined Section 111ÓA read with Section 9 of the Companies Act. Section 9 essentially lays down that the provisions of the Companies Act shall have effect notwithstanding anything to the contrary contained in the memorandum and articles of a company or in any agreement executed by it and any such provision in the memorandum, articles or any agreement shall, to the extent of such repugnance, be void. The High Court held that, as Section 111-A clearly applies in the case of public companies, any agreement in contradiction with it would be void as per Section 9 of the Companies Act. Therefore, the pre-emptive right contained in the shareholders’ agreement was held to be unenforceable. It must be noted here that agreements covered under Section 9 are only those which are executed by the company. Therefore, this judgment does not deal with a situation wherein the agreement is only between the shareholders inter se. Holding Ltd. v. Ruia & Co. 13 In the very recent judgment14 of the Division Bench of the Bombay High Court, the right of pre-emption, as contained in a shareholders’ agreement has been upheld and enforced. Two parties had entered into a share purchase agreement which afforded a right of first refusal to one in the event the other party wanted to alienate its shares to a third party (other than its group company). Taking note of all the above judgments, the Division Bench noted/held the following principles: - Section 22-A of the SCRA was aimed at regulating the right of the Board of Directors of the company to refuse to register transfers arbitrarily. It did not restrict the right of shareholders to deal with their shares or enter into consensual arrangement/ agreement regarding their shares (by way of pledge, pre-emption, sale or otherwise) 15. Section 22-A was deleted simultaneously with the introduction of Section 111-A and the sweep of Section 111-A is the same as Section 22A16; - Section 111-A is not a provision to restrict the rights of the shareholders to enter into consensual arrangement with the purchaser of their specific shares. If the legislature intended to take away that right of the shareholder, it would have made an express provision in that regard17; - Freedom to purchase cannot mean obligation on the shareholder to sell his shares. The shareholder has freedom to transfer his shares on the terms defined by him, such as right of first refusal, subject to compliance with existing regulations18. An agreement of pre-emption entered into by a shareholder and a third party or between shareholders freely, does not restrict “free transferability of shares”19. Such consensual agreements between particular shareholders relating to their shares can be enforced like any other agreements and are not required to be embodied in the articles of association of the company20; and - If an arrangement is only between the shareholders inter se to which the company is not a party, Section 9 does not apply at all21. Critique of the Ruia judgment Notwithstanding the commercial convenience afforded by the law laid down in the Ruia22 judgment, it cannot be disputed that the judgment itself is based on sound legal principles and has provided a much needed wholesome analysis on the issue. The judgment in Western Maharashtra case23 seemed to have overlooked the intricacies of Section 9 of the Companies Act, which clearly invalidates only provisions contained in the memorandum or articles of the company or in any agreement executed by it as are inconsistent with the Companies Act. Therefore, private arrangements between shareholders with regard to only their shares would be outside the purview of Section 9. As an alternative argument, as submitted above, the right to pre-empt is not inconsistent with the right to freely http://www.supremecourtcases.com

Eastern Book Company

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transfer. In fact, one cannot be exercised in the absence of the other. Therefore, even if the company is a party to an agreement wherein private arrangements between shareholders have been recorded, the same should be enforceable as such an agreement would not be contrary to the free transferability of shares of the company (Section 111-A). Concluding remarks This judgment has surely brought about a welcome change in the legal as well as the commercial world. The importance of the enforceability of such pre-emptive rights can hardly be overemphasised in the light of the complexities involved in structuring of transactions in today’s age. Although the judgment is enforceable within the jurisdiction of the Bombay High Court and has persuasive value in other jurisdictions, what remains to be seen is whether the principles enunciated in the judgment are pronounced as law of the land by the Apex Court. - (1901) 1 Ch 279. - Referred to Company Law with Secretarial Practice (13th Edn., Vol. 1) by K.M. Ghosh and Dr. K.R. Chandratre at p. 1566. - Extracts taken from Salmond on Jurisprudence (12th Edn.) by P.J. Fitzgerald at p. 246-53. - Referred to A. Ramaiya’s Guide to Companies Act (16th Edn., Part 1) by Justice Y.V. Chandrachud and Dr. S.M. Dugar at pp. 2056-7. - AIR 1965 SC 1535. - (1992) 1 SCC 160. - (2004) 9 SCC 204. - Supra n. 6. - Ibid. - (2005) 121 DLT 333. - Supra n. 6. - (2010) 154 Comp Cas 593 (Bom). - Appeal No. 855 of 2003 along with Appeal Nos. 840 and 857 of 2003 decided on 1-9-2010 (Bom). - Ibid. - Para 50. - Para 51. - Ibid. - Ibid. - Para 56. - Para 53. - Para 55. - Supra n. 13. - Supra n. 12.

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Eastern Book Company

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