An opinion rendered last month by the Bombay High Court on share transfer restrictions in shareholder agreements and articles of association has set the cat among the pigeons. Re-igniting the long-standing debate about whether any fetter of any nature can at all be contracted by shareholders on freely marketable title to shares held by them, the court has held that any restriction would be per se patently illegal.
The court was dealing with a challenge to an arbitral award governing a pre-emptive right on transfer of shares between two shareholders. A pre-emptive right on transfer of shares – widely conventional in private equity and joint venture relationships – entails one shareholder being required to give another shareholder a chance to buy his shares before the shares can be sold out to third parties.
Section 111A of the Companies Act, 1956 (“the Act”) provides that shares of a “public company” shall be “freely transferable”. Section 3 of the Act requires restrictions on transferability of shares as a defining feature for any “private company”. A company that is not a private company is a public company. Conventional pre-emptive rights such as a right of first refusal, or a right of last refusal or tag-along rights involve the owner of the shares contracting a fetter on “free transferability” in consideration for some other reciprocal promise made to him.
“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,” the court has said, adding the only “plain intendment and meaning of
Section 111A” would be that such rights are “completely contrary to the governing principles of law… patently illegal… something that goes to the root of the matter… The (arbitral) award must, in the circumstances, be held to be contrary to public policy… has ignored the express and specific provisions… lost sight of the very concept of free transferability of the shares of a Public Limited Company… failed to apply the provisions of Section 9 under which overriding force is given to the Act notwithstanding anything to the contrary contained in the Memorandum, Articles or agreement.”
With all deference to the court, it is inescapable that the opinion has been stated at the highest possible strain and can have far-reaching and perhaps unintended consequences, not just for joint venture partners and private equity investors, but also for banks, financial institutions and even for regulators and stock exchanges. By this principle, no encumbrance of any nature can be permitted to affect any shareholding in a public company. A pledge of shares by a shareholder would create a fetter on transfer. So would be a non-disposal undertaking given by shareholders to banks to raise funds either for themselves or for the public companies in which they hold shares. These restrictions would be patently illegal insofar as they cover shares of public companies. To be fair, these aspects do not seem to have been urged before the court, but the law has been laid down and will hold good in the State of Maharashtra, and therefore the commercial capital of the country unless it is stayed or overturned in appeal.
There are other implications too. The court has emphatically stated that “the principle of free transferability must be given a broad dimension… Imposing restrictions on the principle of free transferability is a legislative function… 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.”
The Securities and Exchange Board of India, by subordinate legislation, imposes a “lock-in” on shares held in public companies in certain situations. So do stock exchanges routinely ask substantial shareholders not to transfer their shares for specified periods of time. These measures would be per se illegal too since subordinate law has to necessarily give way to Parliament-made law and cannot impose restrictions higher than the principles laid down by Parliament. (The author is a partner of JSA, Advocates & Solicitors. The views expressed herein are his own.)
E-mail: somasekhar@jsalaw.com
