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Restriction on Transferability of Shares Valid

The investor community heaved a huge sigh of relief with the cloud clearing over the legality of restriction on transferability of shares in a public company. Strategic investors often insist upon restrictive clauses, commonly known as Right of First Refusal clause or Pre-emption clause (ROFR clause) in investment agreements and joint venture agreements.

Such provisions are often reproduced into the articles of association (AOA). Such clauses stipulate that any alienation of securities by pre-identified shareholders can be done only after having first made an offer to the other contracting shareholder and only on such person refusing, can it be alienated in favour of anyone else.

For various reasons, there has been ambiguity for a long time about the enforceability of such (and other related) provisions as regards shares of public companies.

Earlier this year, in Western Maharashtra Development Corporation v Bajaj Auto, a single judge of Bombay High Court ruled that such provisions were violative of Section 111A of the Companies Act, 1956 (Section 111A), which stipulates that securities of public companies have to be freely transferable.

It was held that the expression “freely transferable” should be interpreted in the widest sense in order to fulfil the object of law thereby stating that the restriction on transferability contained in ROFR clause violative of Section 111A.

In a subsequent decision in Messer Holdings Limited v Shyam Madanmohan Ruia, an appellate bench of the Court (hearing an appeal from the decision of a single judge) upheld the legality of a similar ROFR Clause.

The Court, delving into the legislative history behind Section 111A, held that the legislative intention behind enactment of Section 111A was to prevent the Board of Directors from refusing to register the shares in the name of the transferee on their whims and fancies.

It held that the general the expression “freely transferable” in Section 111A cannot be construed to mean that specific shareholders cannot enter into a consensual agreement with the transferee in relation to their shares held by them.

The Court further held such consensual agreements are contractually enforceable like any other agreements and that if the company intends to restrict the shareholders from enforcing ROFR clause then such condition has to be expressly provided in the Articles of Association.

Interestingly, the Court in Messer Holdings has explicitly overruled the Bajaj Auto decision while an appeal in that very matter is pending before the Court.

The judgment in the Messer Holdings case for the time being provides clarity at least as regards ROFR Clauses. However, the debate on Section 111A is far from settled. It is likely that an appeal against the decision of the two-member bench in Messer Holdings will be filed before the Supreme Court.

Then there is the 2009 version of the Companies Bill to be thought of. The Bill is the third attempt in overhauling the current statute, which is the Companies Act, 1956. The Bill does not contain the restriction set out in Section 111A and in fact explicitly allows for insertion of more exacting requirements in the AOA.

However, the Parliamentary committee to whom this Bill was referred to has recommended a whole host of changes, two of which, in some manner, seek to negate this.

By Ankur Kashyap and Bharat Budholia

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