Restriction on Transfer of Shares in a Public Company

(The following Article have been published in the Journal of Chartered Accoutants, Sepember 2011 issue, published by ICAI, New Delhi. This Article is posted here for general and academic purpose only.)

Recent decision of the Bombay High Court in the case of Messer Holing has changed the way to negotiate restriction on transfer of shares in a public company. The decision brought some respite for JV partners however its not provides effective resolution for equity partners and some questions yet to find their standing. This article discusses legal position in reference to the said decision and Companies Bill 2009.

INTRODUCTION

Restriction on share transfer is not only the statutory subject but the business requirements. It would be more interesting if we can see it from management perspective and part of decision making process. Suppose a businessman, entrepreneur in knowledge field, an Investor is planning for new business ventures and considering the gravity of transactions and amount of investments, what would be the right way to do venture with counter part, what precaution should be taken, what understandings should be made now for future contingency and what most important is whether the arrangements being finalized is legally valid. Whether rights and obligations can be enforceable legally before the court and if not find out the alternatives to the extent possible. This is what the roll of professional in decision making process. All these aspects and roll becomes more vital and critical when joint venture party is foreigner. Because to handle laws of multi countries and to correlate each other is a challenging task. Restriction on transfer of shares is management and business decisions. The role of professional is to test such decision in terms of applicable statutory as well as case laws and to ensure it enforceability to serve the ultimate purpose of a venture.

NECESSITY FOR RESTRICTION ON SHARE TRANSFER

The basic thing need to understand is why the restriction on transfer of shares? Restrictions are very much required to meet the strategic reasons in commercial sense. If a person alone doing something there will no need to any understanding. However two or more persons come together for a venture, it is necessary to have understanding about the control and rights of management and transfer of the same. Here control means mainly shares and voting powers. Mainly restriction on share transfer is used in Joint Venture Company (JV).

Practically, if anybody is holding more than 10% shares, it needs to take care. prime facie it appears minority holding and it can not block any resolution but a person with 10 % holding can approach to Company Law Board on ground of operations and mismanagement and many time it is difficult to put the business situation before the authority. Among other because of these business reasons party wants some kind of restrictions on share transfer e.g. ‘First right of refusal’ and ‘Tag along Right’.

Although parities are ambitious in beginning, many times hard facts come to realize in a midway. at some point of time if any party thinks to exit or finds other way or other person to do in different way and accordingly it going to exit, whats about the other party who is willing to continue. The purpose of restriction on share transfer is to protect that party who is willing to continue the venture and to have some understanding in advance to meet the contingency which may arise in between. For example, If two person planning for a JV Company. Its not only the money either or both the parties put in corpus does matter, however some other criteria are also relevant. For example, reputations, business areas, future prospects, professional attitude for investment and business, possibility to align business interest in future of a JV Partner. JV Partners considering all these aspects set a length of way and valuing the walk together. Now if any JV partner it means a Shareholder in a JV Company want to exit, want to dispose of its shares, then whats about the other partner who want to continue on the place and what is more important is whats about the new incoming partner. Whether existing operations or a project of JV Company can be continued smoothly with new shareholders. The vary purpose of share transfer restrictions are to meet such kind of contingencies. Purpose of share transfer restrictions is to protect interest of the parties who is continuing in the JV and overally to set a mechanism in advance to avoid any business and management dead lock. Restrictions are agreed through shareholders agreement which is further incorporated in Articles of Association of the Company (the Articles).

In case of a private company, restrictions on share transfer can be agreed between the shareholders and further incorporated in Articles of the private company and accordingly binding to all the shareholders and the private company. Private company is most preferable vehicle for Joint Venture. In this Articles Author focus on restriction on transfer of shares in a public company registered under the Companies Act 1956.

STATUTORY PROVISIONS AND JUDICIAL PRECEDENTS

Coming on the issue, what is the relevance to discuss the subject matter now? Two  important things, one is back to back decision of Bombay High Court in the case Bajaj Auto Ltd and Messer Holding and other is Companies Bill 2009 which is expected going on floor very soon.

For better understanding, should have quick view about the relevant sections of the Companies Act 1956 (the “Act”).  Section 3 of the Act requires and enables a private company inter alia for restriction on transfer of shares. Section 9 of the Act stipulates that the provisions of the Act shall have effect, notwithstanding anything to the contrary contained in the Memorandum or Articles of Association or Resolution or any Agreement.

Section 111A of the Act is more relevant for the subject matter and it is perhaps most significant unresolved controversy in Indian Corporate Laws. In 1996, The Depositories Act was enacted which omitted section 22A of the Securities Contract Regulation Act 1956 and simultaneously added section 111A to the Act.

In a recent decision of division bench of Bombay High Court in the case of Messer Holing, It is held that private arrangement between the shareholders conferring the right of first refusal means restriction on transfer of shares, is valid and not contrary to the section 111A. However the decision is not conclusive for corporate world and some questions yet to find their standing. Get into the subject, it is useful to have a vivid picture and close analysis of following five decisions by Supreme Court and different High Courts.

1. V B Rangaraj Vs. V B Gopalkrishnan (1992) 1 SCC 160, a decision by the Supreme Court.

2. Mafatalal Industries Ltd Vs. Gujarat Gas Co Ltd (1997), a decision of Gujarat High Court.

3. M.S.Madhusoodhanan Vs. Kerala Kaumudi Pvt. Ltd 2003 Vol.117 Company Cases 19, a decision by the Supreme Court of India.

4. Twin judgments of Bombay High Court in the case of WMDCL Vs. Bajaj Auto Ltd, dated February 15, 2010 and Messer Holding Ltd Vs. Shyam Madnmohan Ruia & Others, decided on September 1, 2010).

It is very important to identify what exactly these decisions hold and relevant to each others and for a public company. It is also necessary to consider the legislative history of Section 111A of the Act and the position of transferability of share in common law.

V B RANGARAJ Vs. V B GOPALKRISHNAN (1992) 1 SCC 160

We should begin with the decision of Supreme Court in the Case of V B Rangraj. In this Case shareholders of a private limited company were two branch of family and it was agreed orally in 1951, it means in backdrop of Independence and partition, that the proportion of the shareholding of respective branches would not change, and further agreed that for this purpose, any member of a branch want to sell his shares must first offer the share to his own branch. The crux in this case is the oral agreement about restriction was not incorporate in Articles. Referring its own earlier relevant decision in Kalinga Tubes, the Supreme Court held that the shares are “freely transferable”  and that a private agreement imposing restriction on transfer of shares which is not stipulated in Articles of association is neither binding to the Company nor to shareholders. It means such kind of agreement is void in toto. One thing very clearly established in this case is any restriction on share transfer must be incorporated in the Articles of the Company otherwise it will not have any effect and aggrieved shareholder can not have any legal remedy against violation of such restrictive provisions of agreement or understanding.

The later part of the decision – that it does not bind the company is not new and is an accepted rule of English Rule. However that it does not bind the shareholders was something strange to Indian Law.

MAFATLAL INDUSTRIES LTD. Vs GUJARAT GAS CO. LTD (1997) – GUJARAT HIGH COURT

The decision of Gujarat High Court in the case of Mafatlal Industries in 1997 is an other important precedent relating to subject matter. This was the case relevant to a public limited company. In this case a shareholder disposes the 3.87% share holding in the open market in violation of the agreed terms. Very interestingly and according to the author, rightly argued that “free transferability” refers to absence of restriction which may be imposed by the third parties, but it cannot exclude the right of a shareholder to impose restrictions on himself in the matter of transfer of shares to another person. This argument was rejected by the then Judge Mr. Shah who pointed out that ratio laid down in the case of V B Rangara by the Apex Court is having much greater force and can be applied to public company also. This decision had changed the whole scenario for public company.

M. S. MADHUSOODHANAN Vs. KERALA KAUMUDI PVT. LTD 2003 VOL.117 COMPANY CASES 19

Now coming on the case of Madhusoodhanan which was decided by the Supreme Court in the year of 2002. This is also in reference to a private limited company. This case arose out of a complex family dispute in Kerala and specifically out of a karar / agreement that provided that “there would be no change in the existing share structure among the family” of the private limited company. It further provided that the shares of two members would pass to Madhusoodanan in a certain percentage on their death. The facts of the case to some extent similar to the case of Rangaraj however the Court had different view and distinguished Rangara and Kaling tubes case and held that this restriction was not on a share as a class but on specific, identified shares between specific and identified members to which the company need not be a party.

WESTERN MAHARASHTRA DEVELOPMENT CORPORATION LIMITED Vs. BAJAJ AUTO LIMITED – FEBRUARY 2010 – BOMBAY HIGH COURT

Now the time bring us to twin important judgment of Bombay High court in the Case of Bajaj Auto Ltd decided in February 2010 and the case of Messer Holding decided in September 2010.

In the Bajaj Auto, In the year 1974, Western Maharashtra Development Corporation Limited and Bajaj auto Limited entered into agreement to incorporate of a JV company named Maharashtra Scooters Limited (MSL) and accordingly the Company was incorporated under the Companies Act as a Public Company. The share of the Company are listed on the BSE and NSE. Western Maharashtra Development Corporation held 27%, Bajaj Auto held 24% and public holding is 49%. In this case there is a Protocol Agreement dated October 2, 1994 (“Agreement”) between the two promoter shareholders restricting transfer of their respective shares which is also incorporated in the Articles of Association. As per the Agreement, if either party desire to sell its shares, such party shall give the first offer to purchase the share to other party at such price as may be agreed. If within 30 days of such intention, the party agrees to purchase the shares then the selling party bound to sell the shares. If the other party willing to purchase the shares however the proposed price is not acceptable to it, the question of the price should be referred to arbitration.

Later, the Petitioner wants to dispose its holding and accordingly offered the shares to the Bajaj Auto at a price of Rs. 232.20 per share which was not acceptable to it. In terms of the Agreement the issue to determine price was referred to the sole arbitrator. The Arbitrator after considering the matter through arbitration award directed to sell share to Bajaj Auto at a price of Rs. 151.63 per share. Aggrieved, the petitioner filed an application before the Hon’ble Bombay High Court.

The Petitioner inter alia argued thatThe Agreement regulating transfer of shares was illegal and void on the ground that (a) the Agreement was a forward contract prohibited by the Securities Contract Regulation Act; and (b) The agreement contained restrictions on the transferability of the shares of MSL which were violative of the provisions of Section 111A read with Section 9 of the Companies’ Act, 1956 and hence void. The Petitioner contended that in terms of section 111A of the Companies Act 1956 which provides for ‘free transferability of shares’ in a public company, the agreement providing for restrictions on share transfer and restrictions embodied in Articles of Association was illegal and therefore any determination there under and arbitral award was void. Section 34 of the Arbitration and Conciliation Act 1996 provides for set aside an arbitration award in some circumstances.  It defines the parameters of recourse to a Court against an arbitral award. Section 28(1) (a) mandates that the arbitral tribunal must decide the dispute in accordance with the substantive law in India. In the case of ONGC vs. Saw Pipes the Supreme Court held that if an award is in contravention of the provisions of any Act, it is subject to judicial intervention and can be set aside.

From other side in response, the counter argument of Bajaj Auto / Respondent was that the restriction imposed by the agreement was valid because it did not bind all shareholders, but only two shareholders in a specific contingency. The restriction has also been incorporated in the Articles of Association of the Company. Based on decision in the case of Madhoosudhanam, It was further argued that section 111A of the Act does not prohibit restriction on transferability when agreed between specific shareholders regarding specific shares.

Single Judge of the Bombay High Court held that the principle of free transferability must be given a broad dimension in order to fulfill the object of the law. 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 Court further held that the Agreement and provision in Articles of Association restricting the transfer shares is violative of section 111A read with section 9 of the Companies Act and therefore it is void and accordingly the award is contrary to substantive provisions of law and is patently illegal.

MESSER HOLDING LIMITED Vs. SHYAM MADANMOHAN RUIA AND OTHERS (September 2010) – BOMBAY HIGH COURT

Now, the latest and most important decision of the division bench of the Bombay High Court in the case of Messer Holding decided in September 2010 has changed the way to negotiate share transfer restrictions in a public company. The decision by the single judge in Bajaj Auto case that restriction on transfer of shares in a public company is contrary to section 111A of the Act, has been now overruled to some extent by the division bench in the case of Messer Holding by declaring that 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 and accordingly such agreement in relation to the specific shares can be enforced like any other agreement. That does not impede the free transferability of shares in a public company at all.

The facts in brief, Bombay Oxygen Ltd is defendant no 2 company was listed on BSE. Messer holding was the major shareholder of the Company. It entered into agreement dated June 23, 1997 where under the German company to acquire shares and management of the company and provide some technology to company. It was condition in the agreement that either party want to sale its share then offer first to other party except some situation as provided in the agreement. In this case, the arguments were (a) the agreement was void because of fraud and misrepresentation (b) the agreement was void because it was in violation of SEBI rules and regulation and (c) the agreement was void as it restrict free transferability in term of section 111A of the Companies Act and recent decision of Bombay High Court in the case of Bajaj Auto.

First time the Court went into legislative history of section 111A of the Act. It was observed that in 1986 Section 22A was introduced in Security Contract Regulation Act 1956. It provides free transferability of shares in a registered company. However a Company can refuse transfer of shares on four specified grounds. The section was introduced in backdrop of series of complaints regarding arbitrary power exercised by the board of directors in refusing or non consideration of request for transfer and transmission of shares. The Court noted that suffice it observe that the intention behind introducing Section 22 A in 1986 was to regulate the right of the Board of Directors to refuse transfer of members share and it was not to impose restriction on the right of shareholder to deal with his shares by entering into consensual arrangement with the third party to which the company need not be a party.

Section 22A was deleted by Depositories Act 1996 and at the same time section 111A of the Companies Act come into picture. The proviso to subsection (2) reinforces the position that Section 111 A 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.

The expression “freely transferable” therein is in the context of the mandate against the Board of Directors to register the transfer of specified shares of the members in the name of the transferee, unless there is sufficient cause for not doing so. The said provision cannot be construed to mean that it also intends to take away the right of the shareholder to enter into consensual arrangement/agreement 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 regard. Reliance has been rightly placed on the decision of the Apex Court in the case of Byram Pestonji Gariwala vs. Union Bank of India (1992) I SCC  which takes the view that the freedom of contract generally, the legislature does not interfere except when warranted by public policy, and the “legislative intent is expressly made manifest” That means it is open to the shareholders to enter into consensual agreements which are not in conflict with the Articles of Association, the Act and the Rules, in relation to the specific shares held by them; and such agreement can be enforced like any other agreement. That does not impede the free transferability of shares at all. Further, such consensual agreements between particular shareholders relating to their shares can be enforced like any other agreements. It is not required to be embodied in the Articles of Association.

In respect to the section 9 of the Act, the Court noted that Clause (a) thereof, which refers to any agreement executed, is in respect of an agreement executed by the company; and not by the shareholder with third party which is a private agreement to which the company is not a party.

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 111 A 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 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 111 A 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.

Viewing the decision of Bombay High Court in the case of Messer Holding, as of now it can be concluded that agreements between particular shareholders relating to and regulating transfer of their shares in a public company can be enforced like any other agreements and it does not impede the free transferability of shares in terms of section 111A of the Act. Further it is not required to be embodied in the Articles of Association.

POSITION AFTER MESSER HOLDING CASE

It is pertinent to note that in the case of Messer Holding, the Bombay High Court has decided the issue in context of shareholders inter se and not shareholders and a Company. The Court kept Company aside by holding that “… shareholders inter se to which company is not a party…”. The effect of the decision is that an agreement between shareholders restricting transfer of shares in a public company is a valid agreement and not repugnant to section 111A of the Act. It signifies that such restrictions in joint venture agreement will remain only as contractual between the shareholders. This implies that they can find only place in agreement but not in Articles of a public company and accordingly its binding to the shareholders and not the Company. In case of violation of such agreement, aggrieved shareholder has to resort lengthy civil jurisdiction.

After the Messer Holding’s judgment, the fundamental difference between private and public company as far as share transfer restrictions are concerned remained the same. In case of private company, restrictions are contractual as well as constitutional provisions as provided in Articles and hence binding and enforceable against all the shareholders and the private company. However the same will not be case for a public company.

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. 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. a crux question comes is what a civil court will do with the company to which the agreement is not binding and it is difficult to declare that the transfer of shares is void when the purchaser is  guarded under  the principle of bona fide purchaser. Effectively a civil court would grant relief in form of compensation or damage for civil breach.

RESTRICTION ON TRANSFER OF SHARES AND COMPANIES BILL 2009

The Companies Bill 2009 (the Bill) intending to make over Indian corporate laws and to replace the Companies Act 1956 with drastic changes was referred to the Standing Committee on September 9, 2009 for examination and report thereon. Probably revised Companies Bill based on the Committee’s report dated August 26 (“Report”) is expected going on table soon. It is interesting to know what would be the standing of the Government about the restriction on transfer of shares in a public company in back drop of the aforesaid twin judgment of the Bombay High Court.

Clause 32 and 52 of the Bill are relevant for issue relating to restriction on transfer of shares in a public company. unlike the section 111A of the Companies Act, 1956, the Bill 2009 does not provides clearly for free transferability of shares in a company however simultaneously it does also not keep much space for such issue. Clause 32 is akin to Section 82 of the Companies Act 1956. It provides that “The shares or debentures or other interest of any member in a company shall be movable property transferable in the manner provided by the articles of the company.” Clause 52 of the Bill deals with power of a Company for refusal to transfer of shares. Legislature intended to make separate provisions for public and private limited company. Sub-clause (1) of clause 52 of the Bill 2009 provides for private company and it is clearly recognized that a private company can have any kind of restriction in its articles on share transfer. Sub-clause (3) of clause 52 deals with transfer of shares in public company, which provides that a public company can refuse transfer of shares on sufficient cause. It is not clear whether any provisions or restriction on share transfer in Articles of a public company would be considered as “sufficient cause”. Viewing the Bill and comparing these two sub clauses, it seems that the Legislature yet to clearly provides in the Bill about restriction on transfer of shares through articles of a public company. In absence of provision in the Bill about free transferability of shares in a public company, ratio and ruling established by the higher courts so far will carry its effect, may be in different footage, in the regime of proposed new corporate laws.

CONCLUSION

In the back drop of the twin judgment of the Bombay High Court – Bajaj Auto and Messer Holding, the Companies Bill 2009 should make clear provisions recognizing the restriction on share transfer in a public company considering present requirement of business in the form of Joint Venture Company. Until the restrictions on share transfer is legally finds place in the corporate laws, the possible way is to have well pre-defined arbitration mechanism in the shareholders agreement. Ruling and findings of the Bombay High Court in the case of Messer Holding, recognizing the private agreement between shareholders is expected to be valid and acceptable even in reference to the Companies Bill 2009.