Share Transfer Restrictions in Shareholders' Agreements - Whether to be incorporated in the Articles of Association of a Public Company?

A Shareholders’ Agreement is a contract to which every shareholder in a company would be a party.  It is an instrument specifying the terms and conditions concerning dispute resolution, the rights, duties, powers and the like of shareholders and procedures as to the management of the affairs of the company.  It may contain provisions to ensure that certain decisions of the company are taken by consensus and discussion instead of the minority being crushed under the majority’s diktat.  It also provides for matters such as restrictions on transferability of shares by way of pre-emption clauses such as ‘right of first refusal’, ‘right of first offer’, and constrained transfer of shares such as ‘tag-along rights’ and ‘drag-along rights’. Unlike the articles of association of a company, a shareholders’ agreement is a private document and may contain certain matters that the parties may desire to be confidential.  Be that as it may, in the context of the private company, the Supreme Court of India, in V. B. Rangaraj v. V. B. Gopalakrishnan, AIR 1992 SC 453, at 455, has held as follows:

“Whether under the Companies Act or Transfer of Property Act, the shares are, therefore, transferable like any other movable property.  The only restriction on the transfer of the shares of a company is as laid down in its Articles, if any.  A restriction which is not specified in the Articles is, therefore, not binding either on the company or on the shareholders.  The vendee of the shares cannot be denied the registration of the shares purchased by him on a ground other than that stated in Articles.”

Subsequent to this judgement, it has it had become common practice to include restrictive covenants in the shareholders’ agreement e.g. in case of joint venture companies such restrictions were being incorporated into the Articles of the company.

The first limb of Sub-section (2) of Section 111A of the Companies Act, 1956 reads as follows:

“Subject to the provisions of this section, the shares or debentures and any interest therein of a company shall be freely transferable:”

In Western Maharashtra Development Corporation Ltd. v. Bajaj Auto Ltd., [2010] 154 Comp Cas 593 (Bom), a pre-emption clause in a shareholders’ agreement was held by the single Judge to be violative of Section 111A of the Companies Act, 1956.

Overruling the above ratio of the judgement, the Division Bench of the Bombay High Court in the case of Messer Holdings Limited v. Shyam Madanmohan Ruia [2010] 104 SCL 293 (Bom) : [2010] 159 Comp Cas 29, held as follows:

“…an agreement by a particular shareholder or between two shareholders relating only to their own shares (by way of pledge, sale or for preemption) is a consensual arrangement entered into by them, in exercise of their right of free transferability and it consequently imposes no restriction on transferability…The concept of free transferability of shares of a public company is not affected in any manner if the shareholder expresses his willingness to sell the shares held by him to another party with right of first purchase (preemption) at the prevailing market price at the relevant time. So long as the member agrees to pay such prevailing market price and abides by other stipulations in the Act, Rules and Articles of Association there can be no violation. For the sake of free transferability both the seller and purchaser must agree to the terms of sale…. The fact that shares of public company can be subscribed and there is no prohibition for invitation to the public to subscribe to shares, unlike in the case of private company, does not whittle down the right of the shareholder of a public company to arrive at consensual agreement which is otherwise in conformity with the extant regulations and the governing laws… 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…”.

Section 111A of the Companies Act, 1956 was inserted by the Depositories Act, 1996 w.e.f. 20.09.1995.  Prior to such insertion, Section 111 of the Companies Act, 1956 was in place, which provided for remedy of appeal to a transferee/transferor who wished to seek relief with regard to the transmission or transfer, of shares in the company, be it a public company or a private company by making an application for rectification of register of members.  Subsequently, sub-section (2) of Section 22A of the Securities Contracts (Regulation) Act, 1956 which came into effect from 17.01.1986 provided that securities of companies are freely transferable.  A company could refuse share transfers only on four grounds specified therein. Section 22A of the SCRA was inserted with the object of regulating, the right to refusal of the board of directors of a company, when transferring members’ shares.  The object of its insertion was never to restrict the right of shareholders to deal with their shares or to enter into any consensual arrangements with regard to their shares, i.e. through preemption rights, calls, puts etc. but rather the legislative intent was to rein the free will that had been given to directors with regard to refusal.

The enactment of the Depositories Act, 1996 omitted Section 22A of the SCRA and introduced Section 111A in the Companies Act, 1956.  Therefore, the intention of the legislature behind introducing these provisions was never to restrict shareholders from entering into any contract or arrangement by and among themselves with respect to the transfer of their individual shares.

The expression “shares… of a company shall be freely transferable” occurring in sub-section (2) of Section 111A of the Companies Act, 1956 is in the context of authority of the board to register the transfer of identified shares of the members in the name of the transferee, unless there is sufficient cause for their refusal to register such transfer of shares.

Sub-section (2) of Section 58 of the Companies Act, 2013 reads as follows:

“Without prejudice to sub-section (1), the securities or other interest of any member in a public company shall be freely transferable:

Provided that any contract or arrangement between two or more persons in respect of transfer of securities shall be enforceable as a contract.”

While the language of the first limb of sub-section (2) of Section 58 of the Companies Act, 2013 and that of Section 111A of the Companies Act, 1956 are almost identical, the new Act has brought in the proviso which appears more as an explanation to the first limb of sub-section (2).  The intention of the legislature behind inserting the proviso seems to be to codify the common law principle as laid down in Messer Holdings Limited v. Shyam Madanmohan Ruia as cited supra.  This has unequivocally laid to rest the uncertainty that was pervading in respect of the covenants pertaining to the rights such as that of pre-emption in shareholders’ agreements.

The moot point that arises for consideration in the context of the proviso to Section 58 (2) of Companies Act, 2013, however, is that whether covenants such as the restrictions on the transferability of shares in the shareholders agreements would continue to be required to be incorporated in the Articles of the public company?

It is pertinent to note that the ratio of V. B. Rangaraj v. V. B. Gopalakrishnan as cited supra would continue to hold the field in the absence of anything to the contrary provided in the regard in the Companies Act, 2013 even if it was in the context of a private company.  Inasmuch as Section 82 of the Companies Act, 1956 is applicable to both public as well as private companies, and since there is nothing provided in the Companies Act, 2013 in respect of the incorporation of restrictive clauses containing in the shareholders’ agreements in the articles of association of a company, except that such agreements are enforceable as contracts.  In such an event, the ratio of V. B. Rangaraj v. V. B. Gopalakrishnan would have to be complied with.