PROJECT

Corporate Law

Topic: Pre-emptive rights Shareholders Agreement Submitted To : Mr. D.P.S Rathore Bahadur Faculty Corporate Law

and

enforceability Submitted By :

of

Aditya Vaibhav & Divye Roll Nos. 10& 51 RMLNLU VIth Sem

1| Page

ACKNOWLEDGEMENT
As a child, you acknowledged everything you accomplished, as you grow older and more sophisticated, you acknowledge only major accomplishments but an endeavor of this magnitude would not have been possible without the invaluable help and support of Mr. DPS Rathore, I express a deep sense of gratitude to him. But I still fail to understand the scarcity of this page to put in the efforts of all those people who helped me and guided me through this small part of the paper that I have completed. Anything that I do in my life is incomplete without the blessings of my God who are my parents only.

2| Page

Index Research Methodology Object of the Project Introduction What is a Shareholders Agreement? Pre-emptive rights for transfer of shares in the Shareholders Agreement Case Analysis Conclusion Bibliography

3| Page

Research Methodology: Doctrinal Research Object of the Project: the object of this project is to discuss the enforceability of the Shareholders Agreement with reference to the pre-emptive rights clause in the light of recent judgements. Introduction Pre-emptive right, the word comes from the Latin verb emo, emere,emi,emptum that literally means to buy or purchase plus the inseparable preposition pre i.e. before. It is a right that is vested in a person natural and legal by the virtue of which he/she can exercise it before any other person can. It is a right that boils down to the rhetoric me first. Pre-emptive rights in law are used in two contexts: (a) International Law: Under international law, a pre emptive right is a synonym for self-defence. Under such an action, a nation uses force against another nation on the flimsy ground that it pre-empted, an attack on it by the other nation and therefore to nip the problem in the bud, it used force on the other nation. The Iraq war , waged by the United States of America in which dictator Saddam Hussein was captured was on the basis of the contention by the then President George .W. Bush that the U.S. had a legal right to use force because of the nature and type of threat posed by Iraq. Moreover it had an inherent right of self defence, recognised in Article 51 of the United Nations Charter. (b) Statutory law: However, the word pre-emptive right is used more in Company Law of various countries around the world. It is used more in the context of Shareholders agreement. A privilege extended to select shareholders of a corporation that will give them the right to purchase additional shares in the company before the general public has the opportunity in the event there is a seasoned offering. A pre-emptive right is written in the contract between the purchaser and the company. When shareholders, usually a majority shareholder or a shareholder committing large amounts of capital to a start-up company, purchase shares, they want to ensure they have as much voting power in the future as they did when they initially invested in the company. By getting pre-emptive rights in its shareholder's agreement, the shareholder can ensure that any seasoned offerings will not dilute his/her ownership percentage. However, the scope of the project would be limited to the Pre-emptive rights relating to shareholding in a Joint Venture Agreement. However , before we commence on the journey on the journey , the meaning of various terms used in a shareholder agreement should be crystal clear. Joint Venture(hereinafterJV): A joint venture is a contractual business undertaking between two or more parties. It is similar to a business partnership, with one key difference: a partnership generally involves an ongoing, long-term business relationship, whereas a joint venture is based on a single business transaction. Individuals or companies choose to enter joint ventures in order to share strengths,

4| Page

minimize risks, and increase competitive advantages in the marketplace. Joint ventures can be distinct business units (a new business entity may be created for the joint venture) or collaborations between businesses. In a collaboration, for example, a high-technology firm may contract with a manufacturer to bring its idea for a product to market; the former provides the know-how, the latter the means. All joint ventures are initiated by the parties' entering a contract or an agreement that specifies their mutual responsibilities and goals. The contract is crucial for avoiding trouble later; the parties must be specific about the intent of their joint venture as well as aware of its limitations. All joint ventures also involve certain rights and duties. The parties have a mutual right to control the enterprise, a right to share in the profits, and a duty to share in any losses incurred. Each joint venturer has a fiduciary responsibility, owes a standard of care to the other members, and has the duty to act in good faith in matters that concern the common interest or the enterprise. A fiduciary responsibility is a duty to act for someone else's benefit while subordinating one's personal interests to those of the other person. A joint venture can terminate at a time specified in the contract, upon the accomplishment of its purpose, upon the death of an active member, or if a court decides that serious disagreements between the members make its continuation impractical. Rights and duties of shareholders - This clause will spell the various rights and duties of the shareholders and the quorum required for participating in the meetings for passing the resolutions, etc. Further, this will also contain the voting rights of the shareholders. Distribution of Shares - The rights related to the issue, sale or subsequent distribution of shares should be clearly defined. It will also include the pre-emptive rights as well as the clause relating to the first refusal rights of the parties. Transfer of Shares - With the passage of time, the directors or the JV partners may want to dispose off their shares. So, a Shareholders Agreement should contain properly defined clauses for sale and purchase of shares so that the overall ratio of share distribution is not altered. Put and call options - In any Shareholders Agreement entered with respect to a joint venture or otherwise, both the parties may not be on an even footing. One party may hold greater interest or valuables than the other, say, one party may be holding rights relating to intellectual property like trade mark, patents, etc. Put and call options are nothing but rights to shareholders to purchase and sell the shares in the Joint venture company. These options will be useful or it will be used as an effective tool in avoiding any deadlock situations, wherein one party may retain one of these rights as a deterrent against deadlock. Usually a call option is contemplated in a JV agreement when one party is having interest more than just a financial interest. By way of this option, the party will call the other to sell his stake compulsorily in the joint venture company. In a downside, the party can exercise call option to exercise control over

5| Page

the JV comp any. Further, a call option is usually triggered when there is a loss of confidence of the Joint Venture partner. Drag along right - A drag along right is a right which permits the right holder who is selling its shares in the JV Company, to force another shareholder to sell his shares alongside. In simple words, when the right holder intends to sell the shares, this right also forces the other shareholder to sell the shares on the similar price and terms and conditions. In this right, the right holder can sell larger proportion of JV Company and this may be advantageous to the third party purchasers. The shareholder with whom this right is exercised will not have any say in the matter regarding price, terms and conditions. Regardless of these facts, the share holder with whom the right is exercised would have to sell his shares. Termination - In the event the partners determine not to continue with the Joint Venture at all, then there should be a clause dealing with termination of Joint Venture. It should also contain in-built mechanism to safeguard the assets and equitable distribution of such assets. Usually there are clauses such as events of default or material breaches which when happened will give a right to the nondefaulting party to terminate the JV/Shareholders Agreement. in this scenario, a drag along right may be incorporated as a default provision, which can only be exercised only on occurring of such events. Dispute settlement - In the Shareholders Agreement, while running the company sometimes disagreements with the partners may occur. Although certain disagreements may not escalate to a full fledged dispute, it is wise and better to put a clause relating to settlement of dispute, if arises in the JV agreement/Shareholder Agreement. There are various forums for resolving the dispute. Arbitration is one amongst them and Arbitration whether ad hoc or institutional is a popular mode for settlement of disputes. Clear-cut methods and procedure to be followed by way of arbitration should be spelled out in the Agreement. Governing Law - A choice is to be taken as to which law will govern the Agreement. Suppose, the JV is being entered into between one Indian party and a foreign party, if the governing law is of India, the general feeling is that as Indian courts are overburdened the same will be dragged on for years in Indian courts. On the other hand, in certain countries, the Courts procedure is fast and efficient. Certain parties while entering into the JV or Shareholders Agreement, if anticipate that dispute may arise, they will choose Indian court procedures instead of opting for foreign courts or for going in favour of Arbitration. So, in choosing the governing law, one should take into account various factors.

What is a Shareholders Agreement? Shareholders Agreement is nothing but a contract between the shareholders of a company or firm, describing in detail their rights, privileges, mutual obligations, protection and of course
6| Page

comprising the companys articles of association or the by-laws. Although a properly constituted Shareholders Agreement protects all the signatories, the provisions of the agreement are made mainly for the minority shareholders. According to section 36 of the Companies Act, 1956, the Memorandum and Articles of Association when registered, shall bind the company and the members thereof to the same extent as if they respectively had been signed by the company and by each member and contained covenants on its and his part to observe all the provisions of the Memorandum and of the Articles, However, it does not create a binding contract (a) between individual members, inter se (b) between a company and its directors (c) between a company and third parties. In order to enforce a Shareholders Agreement, it should not be inconsistent with the provisions of the Companies Act, 1956. Pre-emptive rights for transfer of shares in the Shareholders Agreement Pre-emptive right is nothing but a right or opportunity given to subscribe to the shares of a company, when the company issues fresh shares to a third party. In other words, the preemptive holder has got an opportunity to subscribe to the shares, before the shares are issued to a third party who is not a party to the Joint venture or Shareholders Agreement. A preemptive right is usually exercised at the issue price and on the same terms and conditions that are issued to the outside party. Further, in a joint venture, where the partners are more than just investors, it is a good reason to prevent the third parties to enter the JV Company. In that scenario, the pre-emptive right gives right to the right holder to prevent third parties to enter into Joint venture Company provided the right holder is prepared to pay the asking price. Section 111A of the Companies Act, 1956 provides that subject to the provisions of the section, the shares or debentures and any interest therein of a company shall be freely transferable. Further, section 82 of the Act allows members to lay down the manner in which shares of a company shall he transferable. It may be possible that a company may lay down in the Articles not just the manner of transfer of shares but the terms and conditions pertaining to the same. Further, sect ion 9 of the Companies Act, 1956 provides that save as otherwise expressly provided in the Act, the provisions of the Act shall have effect notwithstanding anything to the contrary contained in the Memorandum of Association (MOA) or Articles of Association (AOA) of a Company or in any agreement executed by it, or in any resolution passed by the Company in general meeting or by its Board of Directors. Any provision contained in the Memorandum, Articles, agreement or resolution shall, to the extent to which it is repugnant to the provisions of the Act, become or be void, as the case may be. The provisions of the Articles will, however, prevail when they are more strict or stringent than what is provided in the Act itself subject to the condition that there is no inconsistency with the provisions of the Companies Act. For example, if the Act prescribes for a particular matter to be transacted, it should be passed by a ordinary resolution hut the Articles have provided that it should he passed by a special resolution, then the provisions of Articles are valid. It can be said that the provisions of law shall override the MOA and AOA
7| Page

and the provisions of MOA shall override those of AOA. So it can be said that unless a provision of the Articles is contrary to law or the Companies Act or the MOA, such provision validly binds all members, present and future. Thus, it is a well-settled law that the Articles of Association of a Company constitute a contract between the members and the Company and the members inter se. A company whether private or public is an association of persons and members may by the provisions of the articles bind themselves in the manner they deem fit. Case Analysis (A) Western Maharashtra Development Corpn. Ltd. v. Bajaj Auto Ltd.1 Facts of the case - A Protocol Agreement was signed in the month of October, 1974 between Western Maharashtra Development Corporation Limited (WMDCL)(Petitioner) and Bajaj Auto Limited (BAL)(Respondent) pursuant to which Maharashtra Scooters Ltd. (MSL) was incorporated under the Companies Act, 1956. MSL was a public company listed on the Stock Exchanges. In accordance with the terms of the said Agreement, WMDCL held 27% of the shareholding of MSL, BAL held 24% and the balance 49% being held by the public shareholders. One of the clauses of the agreement created a right of pre-emption between WMDCL and BAL in the event that either of them sought to part with or transfer its shareholding in MSL, the party desirous to transfer its shareholding was obligated to furnish a first option to the other .for the purchase of the shares at such rate, as may be agreed upon by the parties or by Arbitration. The said protocol was incorporated in the AOA of the MSL to make it binding on the shareholders of the company. The Bombay High Court quoting the provisions of section 111A and section 9 of the Companies Act, 1956 held that The provision contained in the law for the free transferability of shares in a public company is founded on the principle that members of the public must have the freedom to purchase and every shareholder, the freedom to transfer. The incorporation of a company in the public, as distinguished from the private, realm leads to specific consequences and the imposition of obligations envisaged in law. The principle of free transferability must be given a broad dimension in order to fulfil the object of the law imposing restrictions on the principle of free transferability is a legislative function, simply because the postulate of free transferability was enunciated as a matter of legislative policy when Parliament introduced section lilA into the Companies Act, 1956... The effect of a clause of pre-emption is to impose a restriction on the free transferability of the shares by subjecting the norms of transferability laid down in section 111A to a pre-emptive right created by the agreement between the parties. This is impermissible. Section 9 of the Companies Act, 1956 gives overriding force and effect to the provisions of the Act, notwithstanding anything to the contrary contained in the MOA or AOA of a Company or in any agreement executed by it or
1

[2010] 102 SCL 239 (Bom)

8| Page

for that matter in any resolution of the Company in general meeting or of its Board of Directors. A provision contained in the Memorandum, Articles, Agreement or Resolution is to the extent to which it is repugnant is void.

(B) M.S. Madhusoodhan v. Kerala Kamudi (P). Ltd2 The Supreme Court observed that it is a settled law that shares are movable properties and are transferable. As far as private companies like Kerala Kaumudi are concerned, the AOA restricts the shareholders right to transfer and prohibit any invitations to the public to subscribe for any shares in or debentures of the Company. This is how a private company has been defined in section 3(1) (iii) of the Companies Act, 1956. Subject to this restriction, a holder of shares in a private company may agree to sell his shares to a person of his choice. Such agreements are specifically enforceable under section 10 of the Specific Relief Act, 1963 too. The section provides that specific performance of such types of contracts may be enforced when there exists (a) no standard for ascertaining the actual damage caused by the non-performance of the act agreed to be done or (b) when the act agreed to be done is suchFmafat that compensation in money for its non-performance would not afford adequate relief. It is a settled proposition that in case of a contract to transfer movable properties of special value or interest to the plaintiff or consisting of goods which are not easily obtainable in the market, it has been held by the authority that shares of a private limited company would definitely come within the purview of the words not easily obtainable in the market. Thus, the cases involving the restriction on the transferability of shares of a private limited company have to be contrasted to the cases involving public companies where the free transferability of shares is the norm and it gives an unfettered right to transfer the shares. Thus, in the instant case, the Bombay High Court categorically laid down that a pre-emptive right would impose a fetter on the transferability of shares because of the fact that the law permits it only for private limited companies. (C) Katoch v. Manu Maharani Hotels Ltd.3 Facts of the case: the right of pre-emption was contained in the family settlement agreement and not in the Articles of Association. The Delhi High Court noted that Counsel appearing on behalf of the Respondent submitted that section 111A has no application to contracts for (lie transfer of particular shares between
2 3

[2003] 46 SCL 695 [2006] 131 Comp. Case 42

9| Page

particular shareholders when incorporated in the Articles of Association. The submission is that restrictions which bind third parties are bad. Section 111A was intended to curb the power of the Board of Directors to obstruct transfers and clearer words would be required to destabilize bargains which are the heart of commerce. The submission that section 111A would not interdict an agreement between particular shareholders relating to the transfer of specified shares is based on the judgment of the Supreme Court in Madhusoodhanan. In that case, as already noted earlier, the Supreme Court noted that the Karar was an agreement between particular shareholders relating to the transfer of the specified shares. That is significant is that the Company in that case was a private Company. The Supreme Court noted with some emphasis that in the case of a private Company, the Articles of Association would restrict the right of shareholders to transfer shares and prohibit invitation to the public to subscribe for shares or debentures of the Company. The position in law of a Public Company is materially different. By the provisions of the Companies Act, 1956, restrictions on the transferability of shares which are contemplated by the definition of a private company under section 3(1) (iii) are expressly made impermissible in the case of a public company by the provisions of section 111A. Once that is the position, the submission urged on behalf of the respondent cannot be accepted. In essence, the submission of the respondent is that the provisions of section 111A should he read as being subject to a contract to the contrary. A restriction to that effect cannot be read into the provision of section J11A;firsfly because, such a restriction is not mentioned in the statutory provision; secondly, the word transferable is of the widest import; and thirdly, the context in which the provision has been introduced, is susceptible to the inference that it should be given a wide meaning. Where the language of the statute is plain and unambiguous, neither the consequence nor the conduct of parties would be of relevance... The aforesaid judgment has, thus, created a doubt over the enforceability of pre-emptive rights in case of public companies. It has also led to the fact to ponder over whether imposing restrictions in the AOA of the company, pursuant to the power given to the members by virtue of section 82 of the Companies Act, 1956 and which has since been upheld by various courts in a number of cases are continued to be valid or it would become void and cannot be enforced in a Court of law. it can be said that the Delhi High Court while giving the aforesaid judgment did not consider the provisions of section 82 of the Companies Act, 1956 which clearly casts a right on the members to lay down restrictions on the AOA of a Company with regard to transferability of their shares in the company. (D) The case of the Messrs Holding Limited Facts of the case - A Share Purchase Agreement (SPA) was entered into between Bombay Oxygen Ltd. (BOL) and Messer Griesheim Gmbh (MGG) in the year 1997, wherein BOL transferred 45001 shares in favour of MGG. Further, pursuant to an open offer in accordance with the Securities and Exchange Board of India (Substantial Acquisition of Shares and Takeovers) Regulations, 1997, MGG had also acquired another 30000 shares of BOL. MGG had also entered into a separate Share Purchase Co-operation Agreement in 1995 with Goyal MG Gases (P) Ltd. (GMG), a competitor of the company and the same was not disclosed to
10 | P a g e

BOL. The SPA between BOL and MGG contained a Right Of First Refusal (ROFR) in favour of BOL in case of transfer of shares outside the group companies of MGG. But MGG transferred its entire shareholding in BOL to Messer Holdings Ltd. (MHL), a joint venture company in which GMG was holding majority of shares. The issue before the Division Bench of the Bombay High Court was that whether MGG breached the ROFR clause as captured in the SPA. Further, whether the ROFR clause was illegal and void by virtue of section 111A of the Companies Act, 1956. The Division Bench analysed the provisions of the Companies Act as well as the earlier judgments on the issue and observed that the decision in the case of Western Maharashtra Development Corpn. Ltd. (supra), which was given by the Single Judge was on the wrong footing that an agreement of pre-emption, even if freely entered, into by a shareholder and a third party or between the shareholders, does impose restrictions on the transfer of shares, which otherwise are freely transferable by way of provisions which have been specifically contained in the Act. Section 111A (2) of the Companies Act, 1956 states that subject to the provisions of this section, the shares or debentures and any interest therein of a company shall be freely transferable. The Division Bench further observed that transfer of shares and debentures is not to curtail the freedom and rights of the shareholders to enter into separately any private arrangements or understanding for their specific share of shares so long as such rights are in agreement and conformity with the clauses contained in the AOA, the provisions of the Companies Act, 1956 and the rules made there under. Also, the intention of the provisions of section 111A is to give power to the Board of Directors of the Company to transfer the shares in the name of any transferee subject to fulfilment of all the other conditions for transferability unless there is sufficient cause for not doing so. The Division Bench also clarified that had the intention of the Legislature is to take away the rights of the share holders; it would have made an express provision in that regard. But there is no express provision to that effect. The Division Bench analysed sections 9 and 111A of the Companies Act, 1956 and observed that section 111A is not dealing with law relating to the right of the shareholders to enter into any consensual arrangement or an agreement. Thus, any such arrangement between shareholder and third party or shareholders inter se to which the company is not a party, section 9 will not be applicable under any stretch of imagination. The Division Bench further observed and relied on the judgment of the Supreme Court in the matter of M.S. Madhusoodhan stating that consensual agreements between particular shareholders relating to their specific shares do not impose restriction on the transfer of shares. Whereas in Madhusoodhanans case , Supreme Court pointed out that in agreement between particular shareholders relating to the transfer of specified shares did not impose a restriction on the transferability of shares and it was unnecessary for the company or any other shareholder to be a party to the agreement. It was pointed out that this crucial distinction drawn by the Apex Court in the aforesaid two cases has been glossed over by the Single Judge of the Bombay High Court. Division Bench concluded the judgment by stating that any private arrangement of a public company on a voluntary basis relating to share transfer restrictions or Right of First Refusal is not violative of section, 111A and it is not mandatory for the company to be a party to
11 | P a g e

such an agreement relating to share transfer restrictions. Further,, it noted that any agreement between particular shareholders which does not contain and impose a blanket restriction on all the shareholders of a company, can be very well enforced like any other agreements and is not required to be captured or incorporated in the AOA. If arrangement by a particular shareholder relating to his own shares by way of pledge or pre-emption is to be restricted by the company, then there ought to be an express provision in that behalf in the AOA. The intention of section 111A is mainly to restrict the right of directors of the company to refuse transfer of shares. It is not intended to and does not affect the right of shareholders to deal with their specific shares or to enter into any consensual arrangement or agreement regarding their shares (by way of pledge, pre-emption, sale or otherwise). The legal provision of section 111A does not expressly restrict or take away the right of the shareholders to enter into consensual arrangement or agreement in respect of shares held by them. Further, the Division Bench observed that the expression freely transferable mentioned in section 111A does not mean that the shareholder cannot enter into private arrangement with the third party or with proposed transferee in relation to specific shares. Thus, the aforesaid judgment will serve as a welcome measure especially when the judgment of Western Maharashtra Development Corpn. Ltd.s case had created a doubt over the enforceability of pre-emptive rights in case of public companies. Now, with this latest judgment by the Division Bench, the particular shareholders cannot really rely on Western Maharashtra Development Corpn. Ltd. judgment as one of the excuses to back out from the terms and conditions of the Shareholders Agreements.

12 | P a g e

Conclusion Various Shareholders Agreements and Joint venture agreements are being entered into by both public companies, private companies as well as by the Government on day-to-day basis. In almost, all the agreements, there will be clauses relating to rights of first refusal, restriction on transfer of shares, tag along and drag along rights which are the essential clauses and would form integral part of such agreements. The latest judgment by the Division Bench of the Bombay High Court (in the matter of Messer Holdings Ltd. (supra) gives good comfort to particular group of shareholders who want to capture right of first refusal, tag along rights and drag along rights in their mutual consensual agreements/Joint Venture agreements/agreements inter se or with other third parties, however, this Judgment has not yet attained finality and hope to receive further clear- cut clarifications from the Supreme Court on the subject. Thus, the debate on enforceability of the terms of Shareholders Agreement of a public limited company is not yet over. Further, the Ministry of Corporate Affairs should take this judgment or the final decision of the Supreme Court, if any into account in revamping the Companies Bill, 2009 in order to keep this controversy at rest forever.

13 | P a g e

Bibliography
A Ramaiya, Guide to the Companies Act, vol 1 (16th edn, Wadhwa & Co. 2006) Avtar Singh, Company Law, (15th edn, Eastern Book Company 2007) Halsburys Laws of England, vol 48 (4rth edn reissue, LexisNexis Butterworths 2007) Palmers Company Law, (vol 1, 25th edn, Thomson Reuters 2010) C R Dutta on the Company Law (6th edn, Wadhwa & Co. 2008) Blacks Law Dictionary (Bryan A Gardner ed, 9th edn, Thomson Reuters 2009) P. Ramanatha Aiyar, Advanced Law Lexicon (JusticeY V Chandrachud ed, 3 rd edn, Wadhwa & Co., 2005)

14 | P a g e