Certain shareholders are on a tight leash when it comes to selling their stake in a company. Be it through a lock-in period or a ban or selling shares to any competitor, to more reasonable restrictions such as a right of first refusal or offer—basically obligations owed to existing shareholders before transacting with other parties. Such transfer restrictions assume great importance in all corporate transactions—from big-ticket merger and acquisition deals to joint ventures, private equity and venture capital investments. Quite rightly so: These restrictions are the best way to ensure that ownership doesn’t slip into the wrong hands.
However, last month, the Bombay high court in Western Maharashtra Development Corporation v. Bajaj Auto struck down any form of prior or pre-emptive rights over share transfers in public companies, upholding that these shares are freely transferable in absolute terms.
Enforcing transfer restrictions in public companies isn’t easy: The Companies Act, 1956, provides that the shares of a public company are freely transferable. So no public company can restrict share transfers through its charter documents (its articles). Courts have in the past observed that a right of pre-emption, even if found in the articles, would not be permitted.
While this was often assumed to be the law on the subject, shareholders still signed up for transfer restrictions, with hopes that the Supreme Court would one day uphold their rights to create such contractual obligations among themselves.
According to the recent ruling, free transferability means that “every member of the public must have the freedom to purchase and every shareholder the freedom to transfer”. Based on this principle, ideally every shareholder should have the discretion to enjoy the freedom to transfer as per his discretion. And therefore, should a shareholder elect to limit this freedom by contractually agreeing to pre-emptive rights over share transfers for monetary or other forms of consideration, he should be required to honour this contract. However, against this rationale, the high court appears to have upheld free transferability in absolute terms, holding it more important than the contractual rights of shareholders—the principle being that shares are freely transferable under law.
The trouble is the high court’s ruling may conflict with the judicial position adopted by most countries, including the UK where the House of Lords has held that, though an agreement by or among shareholders cannot bind the company, it can certainly bind the shareholders. Further, the extreme view taken by the high court may have far-reaching consequences where all forms of transfer restrictions (including a lock-in) may be negated.
To make matters more confusing, Indian courts have not been consistent in their views on this question. Under the Companies Act, a public company may have an implied right to refuse registering the transfer of its shares, so long as it has “sufficient cause”. Mysteriously, this term has not been defined in the Act, leaving it open to interpretation. So in 2001, the Andhra Pradesh high court in Karamsad Investments v. Nile has observed that if the transfer of shares to a person is likely to create—or, would ultimately place the company itself—in a situation where there is a breach of certain existing contractual obligations, thereby exposing the company to legal action, the company would be justified in refusing to register such transfer of shares. The court ultimately held that there could be various reasons that could constitute such “sufficient cause”, and that it would not be possible to enumerate all of them; they should instead be decided on the facts of each case.
With all these diverging views, concluding what is legally sound for shareholders and companies is difficult until the Supreme Court clarifies the final position. Even so, there may be some hope for the future of corporate ownership in India if a relevant court accepts that, based on the facts of the case, transfer restrictions constitute “sufficient cause”.
Akshay Bhargav, Archana Rajaram and Amrita Singh are attorneys at Nishith Desai & Associates. Comments are welcome at firstname.lastname@example.org