Enforceability of share transfer restrictions

National Law Institute University, Bhopal

A Project on

Enforceability of share transfer restrictions

Submitted to

Dr. Kondaiah Jonnalagadda

Course Teacher

Company Law

Submitted by

Varshita Mangamoori

2008 BA LLB 45

8th Trimester

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 Enforceability of share transfer restrictions

Table of Contents

S.no. Topic Pg. No.

1. Introduction 3

2. Section 111A (2) 4

3. Judicial Opinion 5

4. Analysis 11

5. Conclusion 12

6. Bibliography 14

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 Enforceability of share transfer restrictions

Introduction

“Share transfer restrictions allow control over a transfer of shares to avoid undesirable
business associates and preserve existing interests.”1

Restrictions on the transfer of shares by shareholders generally find their way through
shareholder agreements. In case of restrictions on the transfer of shares of a private company,
the position with regard to their enforceability was settled in V.B. Rangaraj v. V.B.
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Gopalakrishnan where it was held that any restrictions on the transfer of shares such as
right of first refusal, tag along, lock-in, etc., to be enforceable, must be incorporated into the
Memorandum of Association and the Articles of Association of the company. The position
with regard to the enforceability of share transfer restrictions in a public limited company is,
however, not settled. What makes the position of public limited companies different from that
of private limited companies is the fact that free transferability of shares is an essential
characteristic of public limited companies. The Companies Act of 1956 expressly provides
that the shares of a public limited company shall be freely transferable. 3 However, there are
certain situations where parties feel the need to impose certain restrictions on the transfer of
shares. Such restrictions may take the form of tag-along rights, drag-along rights, right of first
offer (ROFO), right of first refusal (ROFR), right of pre-emption, etc. The enforceability of
such transfer restrictions with respect to a public limited company has been an issue for quite
some time.

Section 111 A (2)

1
http://dusmanlaw.com/wp-
content/uploads/2010/07/The_Significance_of_Share_Transfer_Restrictions_for_Closely_held_Corporations_B
y_Derek_P_Usman_Usman_Law_Group_PC_Chicago_Illinois.pdf
2
AIR 1992 SC 453 ; Also see Shanti Prasad Jain v. Kalinga Tubes Ltd., Ainancial Services Ltd., v. The
Custodian and Ors., AIR 2004 SC 5123
3
Section 111A (2)
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 Enforceability of share transfer restrictions

Though the Companies Act has not expressly laid down the grounds on which a public
limited company may refuse transfer of shares, it can be inferred from section 111A (2) that a
company may refuse to transfer shares if it has a ‘sufficient cause’ for doing the same. The
proviso to section 111A (2) provides 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. A cursory look at this proviso would make it seem like a right of the purchaser of
shares to effect registration of purchase. But it can also be construed to be the right of the
company to refuse registration with sufficient cause. ?

The term ‘sufficient cause’ has not been defined under the Companies Act but it would be
pertinent to look at a few judicial pronouncements regarding its meaning. Again, there have
been divergent views.

The Company Law Board, in Estate Investment Company Private Limited and Anr., v. Siltap
Chemicals Limited4, had given a very narrow meaning to the term ‘sufficient cause’. It held
refusal on the grounds that the transfer is in violation of law alone would amount to refusal
due to a sufficient cause. The Company Law Board, in this case, stated in clear-cut terms that
refusal on any other ground would not constitute sufficient cause for refusal.

However, in Karamsad Investments Ltd., and others v. Nile Limited & Others 5, the Andhra
Pradesh High Court had held that the term ‘sufficient cause’ includes within its ambit, not
only all those contingencies that might give rise to a need to undo the transfers but also other
causes and events that might require a company to refuse the transfer of shares. For instance,
a company should be allowed to refuse to register a transfer in favour of a person if such a
transfer would result in or place the company in a situation where existing contractual
obligations of the company are breached. This view was upheld by the Company Law Board
in eFirst Technologies Private Ltd. and Ors. v. Hiperworld Cybertech Limited and Ors.6

4
[1999]96CompCas217 (CLB)
5
[2002]46CLA23(AP)
6
[2005]1s306(CLB)
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 Enforceability of share transfer restrictions

Judicial Opinion

Courts have given divergent opinions on the enforceability of share transfer restrictions in a
public limited company. In Mafatlal Industries Ltd., v. Gujarat Gas Co. Ltd. and Ors.7, a
company had sought to enforce pre-emptive rights over share transfers of a public limited
company. The Articles of Association contained no provision to that effect. The High Court
held that the restrictions could be enforced as they had not been provided for in the Articles
of Association. This judgment implied that even in case of a public limited company, share
transfer restrictions can be enforced if incorporated in the Articles of Association. This issue
was dealt with in the case of Pushpa Katoch v. Manu Maharani Hotels Ltd. and Ors. 8 In this
case, a hotel company was incorporated by four sisters. In a contract, all four of them had
agreed to offer their interest in the hotel to each other before making an offer to a third party,
i.e. each of the remaining sisters had the right of pre-emption in case one of them decided to
sell their stake in the hotel. Though the agreement was recorded in writing and acknowledged
by the Board of Directors, it was not incorporated in the Articles of the Company. In due
course, three of the sisters sold their share in the hotel to a third party after offering them to
the remaining sisters as per the agreement. The sister who had retained her stake in the hotel
could not purchase what was offered to her by the others due to paucity of funds. She needed
more time to arrange the funds and initiated legal proceedings questioning the transfers. The
High Court noted the absence of any pre-emptive rights in the Articles. More importantly, it
concluded that any incorporation of such rights in the Articles would amount to breach of
Section 111A (2) of the Companies Act. In Arjun S Kalro v. Shree Madhu Industrial Estates
Ltd.,9 the Articles entailed that any shareholder desirous of selling his stake or any part of it
must notify the Board of Directors of the same and grant the Board the discretion to
determine the terms of sale. The Company Law Board held that even the granting of such
discretion to finalize sale operates as a restriction on the right of shareholder to freely transfer
shares and any such provisions in the Articles are unenforceable

In Western Maharashtra Development Corporation Ltd. Vs. Bajaj Auto Ltd, 10 a single-judge
bench of the Bombay High Court held that any clause in an agreement that restricts the free
7
[1999] 97 Compcas301 (Guj)
8
121(2005)DLT333
9
[1997] 24 CLA 63 (CLB)
10
MANU/MH/0109/ 2010
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 Enforceability of share transfer restrictions

transferability of shares of a public limited company is void and non-enforceable, even if

such a clause has been incorporated in the Articles of Association. An agreement was entered
into between Western Maharashtra Development Corporation Limited (the petitioner) and
Bajaj Auto Limited (the respondent) pursuant to which the Maharashtra Scooters Limited was
registered and incorporated as a public limited company. According to the terms of the
agreement, 27% of the shares in Maharashtra Scooters Limited were to be held by the
petitioner, 24% by the respondent and the remaining by the public at large. Also, certain other
terms of the agreement reflected that the parties intended to control, at all times, at least 51%
of the shares of Maharashtra Scooters Limited. More importantly, Clause 7 of the agreement
granted a pre-emption right to both the parties, i.e. either party to the agreement intending to
part with its shareholding in Maharashtra Scooters Limited was required to give the other
party the first option to purchase such shares at a price mutually agreed or decided by an
arbitrator. The agreement found its place in the Articles of Association of the Company.

Between 1986 and 2003, the Petitioner had been receiving repeated requests from the
Respondent to divest shareholding in MSL in its favour. In April 2003, the Petitioner had
offered to sell its shares to the respondent at a price of Rs.232.20 per share. The Respondent
confirmed its interest in buying the shares but not at the price stated by the Petitioner. The
parties failed to arrive at a consensus regarding the price of the shares and the matter was
then referred to a sole arbitrator.

When the arbitration process had ended unsuccessfully, the Petitioner filed an application
challenging the jurisdiction of the Arbitrator primarily on grounds that the protocol
agreement was in violation of section 111A(2)11 read with section 9(3)12 of the Companies
Act and therefore, void.

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111A. Rectification of register on transfer

(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.

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Section 9 (b) any provision contained in the memorandum, articles, agreement or resolution aforesaid shall, to
the extent to which it is repugnant to the provisions of this Act, become or be void, as the case may be.
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 Enforceability of share transfer restrictions

The arbitrator, while rejecting this plea of lack of jurisdiction, observed that the protocol
agreement was a private agreement and thus would not fall within the ambit of Section 111A
of the Companies Act. The arbitrator also set a date for the valuation of shares. This arbitral
award was challenged by the petitioner at the Bombay High Court under section 34 of the
Arbitration and Conciliation Act 1996.

The primary issue before the Bombay High Court was with respect to the arbitrator's
jurisdiction- whether the arbitrator had exceeded his jurisdiction in fixation of a date for
valuation for shares on ground that the protocol agreement in itself is illegal and any
determination under the same is void. The petitioners claimed that effectively, there was no
adjudication by the arbitrator as the right of pre-emption incorporated in the agreement was
inoperable in spite of being incorporated in the Articles of Association. They contended that
the Articles of Association have to embody the principles laid down under the Companies
Act; the principle of free transferability of shares in this case. The respondents, on the other
hand, contended that the protocol agreement was legal because it was only entered into by
two particular shareholders with respect to transferability of particular shares and was
incorporated into the Articles of Association.

The Bombay High Court, while analysing the section 34 of the Arbitration and Conciliation
Act 1996 [i.e. the section under which the arbitral award was challenged] observed that the
“illegality” of the matter must go till the root of the award. Therefore, in the present case
before the High Court, the illegality must be regarding section 111A(2) of the Indian
Companies Act.

The Court ruled that the provision regarding free transferability of shares in a public limited
company is founded on the principle that every shareholder must have the freedom to transfer
and every member of public, the freedom to purchase. ‘The principle of free transferability
must be given a broad dimension in order to fulfill the object of the law.’ Imposing
restrictions on the free transferability of shares is a legislative function as the postulate of free
transferability is a matter of legislative policy. ‘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.’ A clause of pre-emption imposes a restriction on the free
transferability of shares in a public limited company and is opposed to the law laid down in
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 Enforceability of share transfer restrictions

section 111A of the Companies Act. ‘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 Memorandum or Articles of a Company or in any agreement
executed by it or 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 to the provisions of the Act, regarded as
void.’

The decision could have had major consequences for joint venture partners, private equity
investors, banks, financial institutions and even regulators and stock exchanges. If a
shareholder of a public limited company is prohibited from agreeing not to transfer his
shares, no fetter or encumbrance of any kind can be created on the share. A pledge of shares
by a shareholder, non-disposal undertakings given by shareholders to banks to raise funds,
etc. would have become illegal. Even the lock-in period imposed by the Securities and
Exchange Board of India in certain situations and stock exchanges would have become per se
illegal.

This decision of the Bombay High Court was overruled by the Division Bench of the
Bombay High Court in Messer Holdings Limited v Shyam Madanmohan Ruia and Ors 13
where inter-alia the validity of a right of first refusal in a share purchase agreement between
shareholders was called to question. In this case, the court held that share transfer restrictions
between two shareholders are valid, enforceable and not in violation of section 111A of the
Companies Act.

Through a Share Purchase Agreement, the controlling shareholders of Bombay Oxygen Ltd
(Company), agreed to part from a majority of their shareholding to Messer Griesheim Gmbh
(MGG). One of the clauses of the agreement provided that if either party intended to sell the
whole or any part of the shares of the Company, the party was to offer the shares to the other
party first. Among other issues, the legality of the said clause is most pertinent. MGG relied
on the decision in Bajaj Auto Ltd that pre-emptive rights on the shares of a public limited
company are contrary to the provisions of section 111A of the Companies Act. The Division
Bench relied on the following while overruling the aforesaid judgment:

Appeal No. 855 of 2003 in Notice of Motion No. 534 of 2002 in Suit No. 509 of 2001 and Notice of Motion
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Nos. 1308 and 3956 of 2005, 4118 of 2007 and 1973 and 1418 of 2008
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 Enforceability of share transfer restrictions

 The historical background of the deletion of section 22A 14 of the Securities Contracts
(Regulations) Act, 1956 by the Depositories Act, 1996 and the introduction of section
111A in the Companies Act indicates that the provisions of section 111A were meant
to regulate the power of the board of directors regarding the transfer of shares,
debentures or any interest in the company. The board of directors cannot refuse any
transfer without having a sufficient reason to do so. Section 111A was introduced to
replace section 22A of the Securities Contracts (Regulations) Act, 1956.

 Section 111A does not deal with the right of shareholders. It does not specifically
impede or snatch the right of shareholders to enter into consensual agreements or
arrangements. ‘Freely transferable’ in section 111A does not mean that a shareholder
cannot enter into consensual agreements or arrangements with another person
regarding his shares.

 Free transferability is not affected if the shareholder expresses his willingness to sell
his shares to another party with right of first purchase, or right of first refusal, or right
of first offer, etc. at the prevailing market rate. There can be no violation as long as
the member abides by the prevailing market price and other stipulations contained in
the Companies Act, SEBI Rules and the Articles of Association.

 Madhusoodhanan’s case is an authority with respect to consensual agreements

between particular shareholders with respect to their specific shares. As rightly held in
the case, such agreements do not impose restrictions on the transferability of shares.
Such consensual agreements can be enforced like any other agreements. They need
not necessarily be incorporated in the Articles of Association. The Bench also relied
on the distinction drawn by the Supreme Court in Madhusoodhanan’s case regarding
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Section 22A of the SCRA provided that the shares of a registered company are freely transferable. However,
the company could refuse transfer only on four specified grounds. The provision was introduced in the backdrop
of a series of complaints against the arbitrary powers exercised by the board of directors of companies in
refusing transfer/transmission of shares in favour of the transferee.
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 Enforceability of share transfer restrictions

the proposition laid down in V.B.Rangaraj’s case. The judgment arrived by the
Supreme Court in V.B.Rangaraj was only on account of the fact that the restriction in
question was a blanket restriction on all shareholders, present and future and could not
be imported to a private agreement between particular shareholders regarding their
specific shares.

Analysis

(1) Freely transferable- The Division bench as given a broad facet to the term ‘freely
transferable’ while holding that free transferability is not fettered in any manner where the
shareholder willingly gives another a right of first offer with respect to his shares at the
prevailing market rate. Such a rationale brings a question as to the enforceability (i.e. whether
or not they fall leave the free transferability of shares unfettered) of exit rights such as put
option and call option agreements where shareholders are obligated to buy or purchase shares
at a price other than the prevailing market price.

(2) Artciles of Association- Decision in V.B.Rangaraj case over-ruled or not?

The Division Bench has specifically stated that such consensual agreements between
particular shareholders relating to their shares can be enforced like any other agreements and
it is not required for such arrangement to be incorporated in the Articles of Association. 
Further, the Division Bench in relying on the Supreme Court’s decision in S.P. Jain v.
Kalinga Tubes has also commented on the non-necessity of a company being party to such
private arrangements between shareholders. Therefore, it would seem like the Supreme
Court’s decision in V.B.Rangaraj that for a company to be bound by the restrictions on
transferability of its shares, the restrictions must be incorporated in the Articles of
Association has been negated by this decision. But this may not be the case. The principles
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 Enforceability of share transfer restrictions

laid down in V.B.Rangaraj were further analysed by the Supreme Court in Madhusoodhanan
and the Court had concluded that the judgment arrived at by the Supreme Court in
V.B.Rangaraj was taking into account the fact that the restriction was a blanket restriction on
all shareholders present and future and could not be imported into a private agreement
between particular shareholders. The principles laid down in V.B.Rangaraj still hold good in
certain circumstances where the provisions are to be enforced against the company. The law
in Messers Holdings is confined only to private agreements between shareholders of a public
limited company.

(3) Liberalization of investor rights

The judgment in Messers Holdings would result in liberalization of transfer of shares and
commercial viability among investors. It may provide relief to private equity investors
regarding enforceability of their rights arising out of private agreements entered into by them.

Conclusion

 Shares of a company are “freely transferable” both as matter of common law and
under the Indian Companies Act (s. 82) and a restriction is “unenforceable unless
contained” in the Articles – VB Rangaraj
 “Freely transferable” refers not to the act of sale, but to the subject of the sale (the
shares themselves) – VB Rangaraj

 The above principle applies with even greater force to a public company, and is
reflected in s. 111A(2), inserted after Rangaraj – Mafatlal Industries

 A general right of pre-emption in relation to the shares of a public company is

contrary to s. 111A – Bajaj Auto

 Madhusoodhanan stands for the general proposition that private arrangements are
legal, and “freely transferable” refers to the freedom of the buyer and the seller –
Messer Holdings

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 Enforceability of share transfer restrictions

 A private arrangement imposing a restriction is enforceable unless barred by the

Articles – Messer Holdings

It is easy to appreciate the adverse commercial consequences of the rule in Rangaraj. It

means that a pre-emption right, ubiquitous in the world of joint ventures, is illegal and
unenforceable. Messer Holdings, by reformulating the Rangaraj rule, averts this
consequence.

However, the better answer lies perhaps in the Supreme Court adopting the rule of English
law that while a restriction does not bind the company, it binds the shareholders. This, for
example, permits a shareholder to obtain an injunction against his fellow shareholders
preventing transfer. Until that happens, Rangaraj continues to be the law of the land, and it is
submitted, with respect, that Messer Holdings is inconsistent with it as a matter of law,
although the result it produces is no doubt commercially desirable. Much of this controversy,
in the ultimate analysis, is perhaps a result of the thin line between Rangaraj and
Madhusoodhanan, and a clarification by the Supreme Court on the relationship between these
judgments, perhaps in the process modifying the Rangaraj rule, will be welcome.

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 Enforceability of share transfer restrictions

Bibliography

1. www.manupatra.com

2. Transfer Restrictions – Would They Hold Up in Court?, Akshay Bhargav, Archana

Rajaram & Amrita Singh, www.nishithdesai.com/.

3. www.indialawjournal.com/volume3/issue.../article_by_Vyapak.html

4. India: Share Transfer Restrictions Enforceable: Bombay High Court,

http://www.mondaq.com/article.asp?articleid=112358
5. Indiacorplaw.blogspot.com

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