Restrictions on a shareholder’s ability to sell his stake in a company usually find its way through shareholders agreements. Be it through a right to first refusal, tag along or restrictions of more absolute nature such as bar on selling shares to another competitor. Based on mutual understanding, investors voluntarily commit to such restrictions. But how would such restrictions legally hold up in courts is a question to be answered.

Under right of first refusal, a private equity investor planning to exit a company is obliged to give the promoters an opportunity to buy the shares before the shares can be sold to a third party. Tag along rights on the other hand, protect minority shareholders by giving them a right to join the transaction and sell their minority stake alongwith the promoter. In a drag along arrangement, the minority shareholder has the right to force the majority shareholder to join the transaction and sell their shares. Given the commercial considerations, these alongwith call and put options, are very common clauses in any private equity investment.

In light of the above, the dispute primarily has been over Section 111A of the Companies Act, 1956 as per which shares of public companies are freely transferable.

A Division Bench of the Mumbai High Court has recently ruled in Messers Holdings Limited v. Shyam Madanmohan Ruia that a private arrangement between shareholders of a public limited company on a voluntary basis relating to share transfer restrictions is not violative of Section 111A. This 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.

The judgment is interesting as it comes in the wake of the single bench Mumbai High Court judgment in Western Maharashtra Development Corporation Ltd v Bajaj Auto Ltd. That judgment had ruled that any pre-emptive rights over shares in public limited companies was illegal in view of the principle of “free transferability” enshrined in Section 111A. Here, the Court took a view that “transferability of shares” should be given a wider meaning and any act restraining transferability of shares is void.

Section 111A provides that there can be no restriction whatsoever on the transferability of shares in a public company. The issue that arises is whether these provisions are intended to curtail the rights of shareholders imposing self-restrictions on transferability of shares.

The principle of free transferability is founded on the principle that every member of the public must have the freedom to purchase and every shareholder the freedom to transfer. Hence, ideally every shareholder should be given the discretion to enjoy the said freedom to transfer according to his discretion. Consequently, should a shareholder elect to limit this freedom by contractually agreeing to preemptive rights over share transfers for monetary or other forms of consideration, he should not subsequently be allowed to breach such contractual obligations on the grounds of free transferability. Free transferability should not be interpreted in absolute terms to negate the inter se rights of shareholders to transfer shares based on their volition.

Given that the provisions of the Companies Act are primarily to administer the affairs of a company, it appears that the purpose of Section 111A is to ensure that a company does not impose any post facto restriction on transferability by refusing to record a transfer after its shareholders have agreed to transfer shares in a particular manner. 

The view taken by the single judge in the earlier case of Bajaj Auto had put the private equity investors in a quandary, with many of them facing the prospect of having to rework their share agreements with external investors. (The Single Bench of the Court in 2010 in its recent decision in Western Maharashtra Development Corporation Ltd. Vs. Bajaj Auto Ltd 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 latest verdict of Mumbai high court has far reaching and welcome effect for private equity investors who, by committing to clauses like right of first refusal, agree to sell their stake to promoters in case they are planning to exit the company. Even the interest of minority stakeholders is protected by giving a legal face to ‘pre-emption clause’. It is pertinent to note that right of first refusal is ubiquitous in the world of joint-ventures. These are guided by commercial considerations, which is the very basis of any collaboration. Giving legal validity to such clauses definitely promotes the interest of shareholders.  

In conclusion, for now, the Mumbai High Court judgment comes as a welcome relief to private equity investors who were otherwise grappling with the myriad issues relating to inter se shareholders’ arrangements. It could result not only in liberalization of transfer of shares, but bring about commercial viability amongst investors. However, since this decision is that of a High Court, the relief granted by this judgment may only be temporary as it is still subject to the affirmation of the Supreme Court.

(The authors are Suresh Swamy - Executive Director and Sheetal Nagle - Associate Director, Financial Services, PricewaterhouseCoopers Pvt. Ltd.)

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