This decision would apply
not just to listed companies but also to other public companies. However, its
significance and wide implications made it a worthy topic for this column.
Shareholders of surely thousands of companies have entered into such agreements
and clearly all these will suddenly find their arrangements disturbed.
The implication is that not
only the company cannot honour such agreements — not even if the terms of this
agreement are incorporated in its articles — but the agreement is void even
between the shareholders themselves.
The decision affects not
merely promoters who often have such agreements amongst themselves but also to
the large number of companies having private equity/strategic investors who are
relatively passive but still hold significant quantity of shares.
Let us make a quick review
of why and how such agreements are entered into. Typically, when two shareholder
groups join together in a company and invest in it, they would like to ensure
that the other group does not exit leaving the former halfway. This is
particularly so in case of investments by private equity and similar investors
who invest on the faith of the main and working promoters continuing with their
stake. There is also usually a certain level of faith on the skills and other
personal qualities of such promoters that prompt them to invest. Such investors
thus insist on certain terms. For example, they require that if the main
promoter seeks to sell his shares, he shall offer those shares to such other
group first at the same price and other terms offered by the outsider (‘right of
pre-emption’). The other group may alternatively ask that his shares be
‘tagged-along’ with the proposed sale and also sold at the same terms offered by
the outsider.
Depending upon the needs and
often the bargaining strengths of the parties, other terms are also agreed upon.
Often the company is also
made a party to such agreements and is required to effectively honour such
agreements, particularly by not allowing transfer of shares that are in
violation of such agreements. This raises the protection, practically and also
legally, since this is consistent with what the Supreme Court held in V. B.
Rangaraj v. V. B. Gopalakrishnan [(1992) 1 SCC 160]. The Supreme Court had
held that for such restrictions to be binding on the company, such terms should
be incorporated in the articles of association of such company.
In a sense, then, it
appeared to be well-settled law, in the light of the aforesaid decision of the
Supreme Court and several other decisions that some of such restrictions are
valid inter-se the shareholders and also binding on the company if they are
incorporated in the Articles. The recent Bombay High Court decision now
overturns this state of affairs.
The facts of the case are
complicated and actually involved appeal against a ruling of an arbitrator on
several issues, but essentially, the issue for discussion here is whether such a
right of pre-emption was valid under law.
The Court considered the
Supreme Court’s decision in Rangaraj and also another Supreme Court’s decision,
i.e., M. S. Madhusoodhanan v. Kerala Kaumudi [(2003) 117 Com. Cases 19].
The Court then analysed the
provisions of S. 111A of the Companies Act, 1956, the relevant Ss.(2) of which
reads as under :
“Subject to the provisions
of this Section, the shares and debentures and any interest therein of a company
shall be freely transferable”. (emphasis supplied)
The aforesaid provision is
applicable to public companies, as compared to the provisions of S. 111 that is
applicable to private companies.
The Court then applied the
provisions of S. 9 of the Act, which says that any provisions in the Memorandum
and Articles, in any agreement entered into by the company or in resolutions,
etc. that is repugnant to the provisions of the Act would be to that extent
void.
The Court also analysed the
meaning of the term ‘freely transferable’ referring to dictionaries and
decisions and also the implications of such restrictive clauses being
incorporated in the Articles of Association of the company.
The Court held that in case
of private companies, the Articles are required by law to provide for
restrictions on transfer of shares. However, the position for public companies
is different. It observed, “situation involving the restriction on the
transferability of shares in a private company has to be contrasted with cases
involving public companies where the law provides for free transferability. Free
transferability of shares is the norm in the case of shares in a public
company”.
When persons form a public
company or buy shares of a public company, they should be conscious that the
shares are, by law, freely transferable and they cannot enter into agreements
that restrict such free transfer. The Court observed :
“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 share-holder, 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. Those who promote and manage public companies assume those obligations. Corresponding to those obligations are rights, which the law recognises as inhering in the members of the public who subscribe to shares.
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 the Parliament introduced S. 111A into the Companies’ Act, 1956. That is a binding precept which governs the discourse on transferability of shares. The word ‘transferable’ is of the widest possible import and the 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 particularly relied on a decision of the Delhi High Court in Smt. Pushpa Katoch v. Manu Maharani Hotels Ltd., [121 (2005) DLT 333] where too the grievance was that some shareholders, in violation of the agreement between the shareholders, transferred their shares without offering to others. The Court held that no provision was made in the articles of association recognising such restriction. Morever, even if such a restriction was contained, such restriction would have been void since the provisions of Act override the Articles and make contrary provisions void u/s.9. This part is as important as it is controversial, since it now holds that even a specific provision in the Articles of the company will not help — in fact, even this provision would be void.
The Court specifically rejected the argument that private agreements could still be made for such restrictions. The Court rejected the argument that the provisions of S. 111A were intended to curb the directors from refusing the transfer of shares.
To reiterate, the decisions would have far-reaching implications both for existing and new arrangements. Numerous companies, listed and unlisted, have entered into some form of such agreements to provide for rights for preemption and similar other restrictions. If the decision reflects the correct state of law, all these agreements would be deemed to be void.
It is submitted that, with great respect, this decision requires reconsideration on several grounds.
Firstly, the decision incorrectly relies on S. 9 which holds that provisions contained in articles, agreements, etc. that are contrary to the provisions of the Act are void. S. 9 clearly refers to such provisions in the “articles of a company, or in any agreement executed by it.”. Thus, S. 9 applies only where the company is a party and I also submit that it makes even such agreement void only as far as the company is concerned. While in the early part of the decision, the Court refers to the exact wording of this Section, in the concluding part, the Court observes that “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.”. I submit respectfully that the Court has cast the net unjustifiably wider and has held even agreements to which the compa-ny is not a party to be void on account of S. 9 when that Section covers only agreements to which the company is a party.
Even the provisions of S. 111A are read out of context and particularly out of the mischief that provision was designed to cure. If one reads the heading of S. 111A, it reads ‘Rectification of register of transfer’. Even its originating S. 111 has the heading ‘Power to refuse registration and appeal against refusal’. If one traces the history and purpose of this Section, they were meant to cover the circumstances under which the Board of Directors of a company can refuse transfer of shares. Indeed, simultaneous with the introduction of S. 111A, the counterpart provision in the Securities Contracts (Regulation) Act, 1956, S. 22A, was omitted and this S. 22A dealt with the circumstances under which transfer of shares of a listed company could be refused.
S. 111A was also introduced in the context of demate-rialisation of shares and dealing of transfer of shares by a depository. In case of dematerialised shares, the transfer takes place electronically and there is no formal process of approval by the Board. In fact, for this reason itself, S. 111A was introduced to provide for ‘rectification’ post-transfer and a fairly wide power is given for raising objections against transfers taken place and reverse them.
However, having said that, it has to be conceded that the intention was also to emphasise free transferability of shares. The technical argument also could be that when the words itself are clear and unambiguous, one cannot refer to headings, history, etc.
Nevertheless, the scheme of provisions does point to the role of the company and its Board in inter-fering with transfer of shares. In fact, even for the Board, specific power has been given to interfere when there are specified factors present, such as violation of laws, etc. or even generally if there is ‘sufficient cause’.
Having stated the above, it is also apparent that many of these defensive arguments were actually raised before the Court and the Court did consider and rule on them. Thus, it may be tough to argue that the decision should have restricted application.
While one hopes that there is an early re-consideration of this decision at a higher appellate level, companies and promoters will have to be careful as regards their existing agreements and also new ones.
